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

                             FORM 10-Q

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

         For the quarterly period ended September 30, 2006

                 Commission File Number 333-63825

                    SCOTIA PACIFIC COMPANY LLC
      (Exact name of Registrant as Specified in its Charter)

                  Delaware                                     68-0414690
        (State or other jurisdiction                        (I.R.S. Employer
     of incorporation or organization)                   Identification Number)

               P. O. Box 712                                      95565
     125 Main Street, 2nd Floor                               (Zip Code)
             Scotia, California
  (Address of Principal Executive Offices)

Registrant's telephone number, including area code: (707) 764-2330

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

     Indicate by check mark whether the Registrant is a large accelerated filer,
an accelerated filer, or a non-accelerated filer. (Check one):
Large accelerated filer        Accelerated filer         Non-accelerated filer X

     Indicate  by check mark  whether  the  Registrant  is a shell  company  (as
defined in Rule 12b-2 of the Exchange Act).
Yes     No X

     Registrant meets the conditions set forth in General Instruction  (I)(1)(a)
and (b) of Form  10-Q  and is  therefore  filing  this  Form  with  the  reduced
disclosure format.

                          TABLE OF CONTENTS

                                                                           Page
PART I.  -  FINANCIAL INFORMATION

         Item 1.   Financial Statements (unaudited):
                   Balance Sheets..............................................
                   Statements of Income (Loss).................................
                   Statements of Cash Flows....................................
                   Condensed Notes to Financial Statements.....................

         Item 2.   Management's Discussion and Analysis of Financial Condition and
                       Results of Operations...................................

         Item 3.   Quantitative and Qualitative Disclosures About Market Risk..

         Item 4.   Controls and Procedures.....................................

PART II.  -  OTHER INFORMATION

         Item 1.   Legal Proceedings...........................................
         Item 1A.  Risk Factors................................................
         Item 6.   Exhibits....................................................
         Signature ............................................................

APPENDIX A - GLOSSARY OF DEFINED TERMS.........................................

                           SCOTIA PACIFIC COMPANY LLC

                                 BALANCE SHEETS
                            (In millions of dollars)

                                                                                       September 30,  December 31,
                                                                                           2006           2005
                                                                                      -------------- ----------------
                                                                                               (Unaudited)
Assets
Current assets:
  Cash and cash equivalents                                                            $    1.6       $    1.3
  Marketable securities, including restricted amounts of $8.9 and
     $23.0, respectively                                                                    8.9           24.2
  Receivables from Palco                                                                    7.6            4.5
  Prepaid timber harvesting costs                                                           5.8            6.0
  Other current assets                                                                      1.8            1.5
                                                                                      -------------- ----------------
     Total current assets                                                                  25.7           37.5
Timber and timberlands, net of accumulated depletion of $302.4 and
  $298.1, respectively                                                                    212.3          219.5
Property and equipment, net of accumulated depreciation of $24.9 and
  $22.6, respectively                                                                      30.3           29.3
Deferred financing costs                                                                    9.5           10.5
Restricted cash, marketable securities and other investments                                4.3            2.5
Intangible assets                                                                           2.2            2.9
                                                                                      -------------- ----------------
                                                                                      $   284.3      $   302.2
                                                                                      ============== ================

Liabilities and Member Deficit
Current liabilities:
  Payables to Palco                                                                   $     1.5      $     1.1
  Accrued interest                                                                         11.4           23.8
  Deferred revenue                                                                          4.0              -
  Other accrued liabilities                                                                 2.4            2.4
  Short-term borrowings and current maturities of long-term debt, excluding
    $7.3 and $11.1, respectively, of repurchased Timber Notes held in the
    SAR Account                                                                            74.3           49.4
                                                                                      -------------- ----------------
    Total current liabilities                                                              93.6           76.7
Long-term debt, less current maturities and excluding $37.0 and $44.3, respectively,
  of repurchased Timber Notes held in the SAR Account                                     643.1          669.6
Other noncurrent liabilities                                                                0.2            0.4
                                                                                      -------------- ----------------
    Total liabilities                                                                     736.9          746.7

Contingencies (See Note 5)

Member deficit                                                                           (452.6)        (444.5)
                                                                                      -------------- ----------------
                                                                                      $   284.3      $   302.2
                                                                                      ============== ================

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

                       SCOTIA PACIFIC COMPANY LLC

                       STATEMENTS OF INCOME (LOSS)
                        (In millions of dollars)

                                                    Three Months Ended           Nine Months Ended
                                                      September 30,              September 30,
                                                 -------------------------- --------------------------
                                                      2006         2005       2006         2005
                                                 ------------ ------------- ------------ -------------
                                                                       (Unaudited)

Log sales to Palco                               $     23.6   $      25.7   $     46.6   $      59.2
                                                 ------------ ------------- ------------ -------------
Operating expenses:
  General and administrative                            5.8           8.2         15.2          22.3
  Depletion, depreciation and amortization              3.2           3.3          7.3           8.8
  Gain on sale of timberlands                          (4.1)            -         (9.1)            -
                                                 ------------ ------------- ------------ -------------
                                                        4.9          11.5         13.4          31.1
                                                 ------------ ------------- ------------ -------------
Operating income                                       18.7          14.2         33.2          28.1
                                                 ------------ ------------- ------------ -------------

Other income (expense):
  Interest and other income                             0.2           1.1          0.6           2.3
  Interest expense                                    (14.0)        (14.1)       (41.9)        (41.6)
                                                 ------------ ------------- ------------ -------------
                                                      (13.8)        (13.0)       (41.3)        (39.3)
                                                 ------------ ------------- ------------ -------------
Net income (loss)                                $      4.9   $       1.2   $     (8.1)  $     (11.2)
                                                 ============ ============= ============ =============

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

                      SCOTIA PACIFIC COMPANY LLC

                       STATEMENTS OF CASH FLOWS
                       (In millions of dollars)

                                                                                              Nine Months Ended
                                                                                                September 30,
                                                                                          --------------------------
                                                                                              2006         2005
                                                                                          ------------ -------------
                                                                                                 (Unaudited)
Cash flows from operating activities:
  Net loss                                                                                $   (8.1)    $    (11.2)
  Adjustments to reconcile net loss to net cash
    used for operating activities:
    Depletion, depreciation and amortization                                                   7.3            8.8
    Gain on sale of timberlands                                                               (9.1)             -
    Amortization of deferred financing costs                                                   1.0            1.0
    Increase (decrease) in cash resulting from changes in:
      Receivables from Palco                                                                  (3.1)          (7.3)
      Prepaid timber harvesting costs                                                          0.2           (0.2)
      Payables to Palco                                                                        0.4            0.4
      Accrued interest                                                                       (12.4)         (12.8)
      Deferred revenue                                                                         4.0              -
      Other accrued liabilities                                                                  -            0.6
      Other                                                                                   (0.3)          (0.6)
                                                                                          ------------ -------------
      Net cash used for operating activities                                                 (20.1)         (21.3)
                                                                                          ------------ -------------

Cash flows from investing activities:
  Sales and maturities of marketable securities                                              122.9          108.7
  Purchases of marketable securities                                                        (121.7)        (107.6)
  Net proceeds from sale of assets                                                            13.1              -
  Net proceeds from restricted cash                                                           12.2            9.1
  Capital expenditures                                                                        (4.4)          (4.8)
                                                                                          ------------ -------------
      Net cash provided by investing activities                                               22.1            5.4
                                                                                          ------------ -------------

Cash flows from financing activities:
  Principal payments on Timber Notes and other timber related debt                           (18.2)         (15.6)
  Borrowings under line of credit agreement, net                                              16.5           31.4
                                                                                          ------------ -------------
      Net cash provided by (used for) financing activities                                    (1.7)          15.8
                                                                                          ------------ -------------

Net increase in cash and cash equivalents                                                      0.3           (0.1)
Cash and cash equivalents at beginning of period                                               1.3            0.5
                                                                                          ------------ -------------
Cash and cash equivalents at end of period                                                $    1.6     $      0.4
                                                                                          ============ =============

Supplemental disclosure of cash flow information:
  Interest paid, net of interest paid in respect of the Timber Notes
     held in the SAR Account                                                              $   53.3     $     53.4

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

                       SCOTIA PACIFIC COMPANY LLC

                CONDENSED NOTES TO FINANCIAL STATEMENTS

1.   Basis of Presentation

     The  information   contained  in  the  following  notes  to  the  financial
statements  is condensed  from that which would  appear in the annual  financial
statements; accordingly, the financial statements included herein should be read
in conjunction with the financial statements and related notes thereto contained
in the Form 10-K. Any capitalized  terms used but not defined in these Condensed
Notes to Financial  Statements  are defined in the  "Glossary of Defined  Terms"
contained in Appendix A.  Accounting  measurements  at interim dates  inherently
involve  greater  reliance  on  estimates  than  at year  end.  The  results  of
operations for the interim periods  presented are not necessarily  indicative of
the results to be expected for the entire year.

     The financial  statements  included  herein are  unaudited;  however,  they
include all  adjustments of a normal  recurring  nature which, in the opinion of
management,  are necessary for a fair presentation of the financial  position of
the Company at  September  30,  2006,  the results of  operations  for the three
months and nine months ended September 30, 2006 and 2005, and the cash flows for
the nine months ended September 30, 2006 and 2005. The Company is a wholly owned
subsidiary  of  Palco,  which is a wholly  owned  subsidiary  of MGI.  MGI is an
indirect wholly owned subsidiary of MAXXAM.

     Liquidity and Cash Resources

     Future Harvest Levels
     The Company has  conducted  extensive  reviews and  analyses of its assets,
operations  and future  prospects.  As a result of these  extensive  reviews and
analyses,  the  Company  has  concluded  that,  in the  absence  of  significant
regulatory  relief and  accommodations,  its future annual timber harvest levels
and cash  flows  from  operations  for at least the next  several  years will be
substantially  below  both  historical  harvest  levels and the  minimum  levels
necessary  in order  to allow it to  satisfy  its debt  service  obligations  in
respect of the Timber  Notes.  The Company  has  previously  disclosed  that its
estimated  average annual harvest levels over the ten-year  period  beginning in
2006 is  estimated to be  approximately  100 million  board feet per year.  This
harvest  level  reflects  the  Company's  estimate of the  cumulative  impact of
ongoing regulatory limitations, watershed prescriptions, the requirements of the
HCP and other  matters and is based on a number of  assumptions  that may or may
not prove to be accurate.  Actual harvest levels may even be lower, depending on
the outcome of various assumptions.

     Regulatory Matters
     Regulatory and environmental  matters as well as legal actions have had and
are expected to continue to have a significant  adverse  effect on the Company's
operations and liquidity. The ability to harvest Company Timber depends in large
part upon the Company's ability to obtain  regulatory  approval of its THPs. The
Company has experienced  difficulties  and delays in the approval of its THPs as
the result of regulatory and litigation  challenges and expects these challenges
to  persist.  The  foregoing  matters  have  resulted  in declines in actual and
expected  harvest  levels and cash flows,  significant  increases in the cost of
logging operations and increased costs related to timber harvest litigation, all
of which have severely  impacted the  historical  cash flows of both the Company
and Palco. These adverse effects are expected to continue.

     The North  Coast Water  Board is  requiring  the Company and Palco to apply
various waste discharge  reporting,  mitigation and erosion control requirements
in respect of timber harvesting activities in several watersheds,  and is likely
to impose  additional  measures  in the  future.  The North Coast Water Board in
December 2003 directed its staff to formulate  WWDRs for the  Freshwater and Elk
River  watersheds  on the  Company  Timberlands.  THPs in these  two  watersheds
represent a significant  portion of the harvest planned in 2006 and for the next
several years.

     On May 8, 2006,  the North Coast Water Board adopted the Freshwater and Elk
River WWDRs.  The decision  allows  harvesting  in these two  watersheds,  up to
approximately  50% of the applicable  CDF Harvest  Limit,  once the staff of the
North Coast Water Board reviews and enrolls THPs  submitted by the Company.  The
North Coast Water  Board's  decision  also allowed the  enrollment of additional
THPs, bringing the total to approximately 75% of the CDF Harvest Limit for these
two  watersheds,  upon  approval of a monitoring  and  reporting  program by the
Executive  Officer of the North Coast  Water Board  staff.  The  monitoring  and
reporting program was approved on September 29, 2006, allowing enrollment by the
staff of the  North  Coast  Water  Board of the  additional  THPs for  these two
watersheds  planned for harvest in 2006. This  monitoring and reporting  program
will also govern future THPs in these two watersheds.  However,  there can be no
assurance  that  additional  THPs in these two  watersheds  will  ultimately  be
enrolled or harvested as planned in 2006 or future years.  The North Coast Water
Board's  adoption of these WWDRs has been appealed to the State Water Board, but
the appeals are being held in abeyance in order to see how the implementation of
the WWDRs proceeds.  As harvesting  activities on the Company Timberlands cannot
readily be moved between watersheds due to, among other things, historic harvest
patterns,  adjacency restrictions,  and the age classes of trees, development of
WWDRs and the various other matters  described  herein are expected to result in
reduced harvest levels in 2006 and beyond.

     Liquidity Update
     In the absence of significant  regulatory  relief and  accommodations,  the
Company's  annual timber harvest levels and cash flows from operations will, for
at least the next several years, be substantially  below both historical  levels
and the  minimum  levels  necessary  to allow the  Company to  satisfy  its debt
service obligations in respect of the Timber Notes.

     In an effort to address the expected  future interest  payment  shortfalls,
the  Company  initiated  the  Land  Sale  Program  to  sell  certain  timberland
properties, as well as various non-timberland properties, such as ranchlands and
recreational  areas. The Company expects that all of the net proceeds from sales
under the Land Sale  Program  will be  available  to pay  interest on the Timber
Notes,  in  accordance  with the Timber Notes  Indenture.  During the first nine
months of 2006,  the Company  sold  properties  available  under the program for
$13.1 million.  The aggregate estimated market value of the remaining properties
included in the Land Sale Program  should cover the  Company's  expected  future
interest payment shortfalls, and the sale of enough of these properties to cover
the expected future interest  payment  shortfalls  should not materially  reduce
estimated  average annual  harvest levels over the next decade.  There can be no
assurance that the marketing  efforts for the Land Sale Program  properties will
be  successful  or that the  resulting  proceeds,  if any, will be sufficient to
cover the Company's expected future interest payment shortfalls.  The properties
included in the Land Sale Program may change from time to time.

     In an effort to address the Company's 2006 operating cash  shortfalls,  the
Company and MGI consummated three timber/log purchases that provided the Company
an  aggregate  of $8.1  million of  additional  liquidity  to pay its  expenses,
including  interest  due in  respect of the  Timber  Notes on the  Timber  Notes
payment dates in January 2006 and July 2006, as discussed  below.  In July 2006,
the Company also requested that Palco make an early payment of $2.1 million,  in
respect of certain  logs that had already  been  delivered  to and  purchased by
Palco from the  Company.  Palco  approved and  delivered  the early log payment,
which  was  used to pay the  Company's  expenses,  including  a  portion  of the
interest due in respect of the July 2006 Timber Notes payment date.

     On the Timber  Notes  payment  date in January  2006,  the Company used its
existing cash resources,  all of the remaining funds available under the Line of
Credit,  and the additional funds made available from a $2.3 million  timber/log
purchase by MGI, to pay all of the $27.7 million of interest due ($25.8  million
net of interest  due in respect of Timber  Notes held in the SAR  Account).  The
Company  also repaid  $19.3  million of  principal  on the Timber  Notes  ($11.9
million net of principal in respect of Timber Notes held in the SAR Account), an
amount equal to Scheduled Amortization, using funds held in the SAR Account.

     On the  Timber  Notes  payment  date in July  2006,  the  Company  used its
existing cash resources,  all of the remaining funds available under the Line of
Credit,  $10.2  million  of funds  from the Land Sale  Program,  a $3.7  million
timber/log  purchase by MGI, and the $2.1 million  early log payment by Palco to
pay all of the $27.1 million of interest due ($25.4  million net of interest due
in respect of Timber  Notes held in the SAR  Account).  The Company  also repaid
$10.0 million of principal on the Timber Notes ($6.2 million net of principal in
respect of Timber Notes held in the SAR  Account),  an amount equal to Scheduled
Amortization, using funds held in the SAR Account.

     As noted above,  the Company also expects to continue to incur  substantial
interest payment shortfalls over at least the next several years. The failure of
the  Company  to pay all of the  interest  on the  Timber  Notes  when due would
constitute an event of default under the Timber Notes Indenture. There can be no
assurance  that  the  Company  will be able to  generate  sufficient  additional
liquidity to fund the expected  future cash  shortfalls.  To the extent that the
Company is unable to generate sufficient liquidity from the Land Sale Program or
other sources,  the Company expects that it will be forced to take extraordinary
actions,  which  may  include:  laying  off  employees,  shutting  down  various
operations, and seeking protection by filing under the Bankruptcy Code.

     Palco Liquidity Update
     As of December 31, 2005, and June 30, 2006, Palco and Britt were in default
under the Old Palco Term Loan and the Old Palco Revolving Credit Facility due to
financial covenant breaches. In the first half of 2006, additional liquidity was
needed at Palco and Palco  borrowed an  aggregate  of $20.0  million from MGI to
meet its cash shortfalls.  Palco's liquidity shortfalls during the first half of
2006 resulted primarily from reduced log supply from the Company and operational
inefficiencies  related  to the  large log  processing  line at  Palco's  Scotia
sawmill.

     On July 18, 2006,  Palco and Britt,  as Borrowers,  closed on the New Palco
Term Loan,  a  five-year  $85.0  million  secured  term loan,  and the New Palco
Revolving  Credit  Facility,  a  five-year  $60.0  million  secured  asset-based
revolving  credit  facility,  and  terminated  the Old  Palco  Revolving  Credit
Facility  and the Old Palco Term Loan.  The New Palco Term Loan was fully funded
at closing.  The New Palco Term Loan and the New Palco Revolving Credit Facility
required  MGI to provide a $10.0  million  subordinated  loan to the  Borrowers,
which was also funded at closing.  The Borrowers  used  approximately  (i) $34.0
million  of the New Palco  Term Loan to pay off the Old Palco  Term  Loan;  (ii)
$22.5  million  of the New Palco  Term  Loan to pay off the Old Palco  Revolving
Credit Facility and cash  collateralize  previously-existing  letters of credit;
and (iii) $6.0 million to pay transaction  costs. The remaining $32.5 million of
loan  proceeds  were used for general  corporate  purposes.  As of September 30,
2006, $84.6 million was outstanding under the New Palco Term Loan, $10.8 million
was outstanding  under the New Palco Revolving Credit Facility,  and the maximum
remaining  availability  under the New Palco Revolving Credit Facility was $36.5
million.

     The amount  available for borrowings  under the New Palco Revolving  Credit
Facility  is  normally  the  sum  of 85% of  the  Borrowers'  eligible  accounts
receivable  plus the lesser of (i) 80% of the book value of Borrowers'  eligible
inventory or (ii) 85% of the net orderly  liquidation  value of such  inventory.
However,  during  each  period  from  October 15 through  January 15, the amount
available for borrowing under the New Palco Revolving Credit Facility is the sum
of 95% of Borrowers'  eligible accounts receivable plus the lesser of (i) 90% of
the book value of Borrowers'  eligible  inventory or (ii) 95% of the net orderly
liquidation  value of such inventory.  The amount  available under the New Palco
Revolving  Credit Facility may not exceed $60.0 million,  subject to limitations
such as the ability of the lender to establish reasonable reserves.

     The New Palco Term Loan  bears  interest  at the rate of LIBOR plus  8.75%.
Loans under the New Palco Revolving Credit Facility bear interest at the rate of
LIBOR  plus  2.75% or prime  plus  0.75%,  at the  Borrowers'  option;  however,
incremental borrowings made during the period from October 15 through January 15
bear  interest  at the  rate of  LIBOR  plus  4.50%  or  prime  plus  2.50%,  as
applicable.

     Both the New Palco Term Loan and the New Palco  Revolving  Credit  Facility
contain substantially  identical restrictive covenants that limit the Borrowers'
ability to incur debt,  grant  liens,  make  investments,  pay  dividends,  make
capital  expenditures  or merge or  consolidate,  and require the  Borrowers  to
maintain  specified  minimum  levels  of  EBITDA  throughout  the  life  of  the
facilities  and  specified  minimum  fixed  charge  coverage  ratios and maximum
leverage ratios commencing  December 31, 2007. The operating cash flow estimates
used to  establish  the EBITDA  maintenance  covenant are subject to a number of
assumptions  about future  operating  cash flows and actual results could differ
materially  from  these  estimates.  The New Palco Term Loan also  requires  the
Borrowers to repay a substantial portion of the outstanding principal of the New
Palco  Term  Loan with the net  proceeds  from  various  required  asset  sales,
including the real property  associated with Palco's former Fortuna and Carlotta
sawmills,  and Palco-owned  homes to be sold after certain  milestones have been
met. Any  remaining  principal  balance of the New Palco Term Loan is due on the
maturity date. Accordingly,  continued compliance with these new debt facilities
is  dependent  on  Palco's  ability to meet its  EBITDA  projections  and timely
complete required asset sales. There can be no assurance that Palco will be able
to meet these financial covenants in future periods. The New Palco Term Loan and
the New Palco Revolving Credit Facility contain  customary events of default and
customary remedies with respect to the occurrence of an event of default and are
each  secured by a  security  interest  in the stock of Palco  held by MGI,  and
substantially  all of the assets of the  Borrowers  (other than  Palco's  equity
interest in the Company).

     The Borrowers did not meet the required minimum EBITDA maintenance covenant
for the three  month  period  ended  September  30,  2006,  due to an  unplanned
severance  charge and a legal  settlement.  The Borrowers  expect the lenders to
issue a limited waiver of the default through December 14, 2006. Until such time
as the default is resolved,  amounts  outstanding  under the New Palco Term Loan
and the New Palco  Revolving  Credit  Facility have been classified as a current
liability  in MAXXAM's  consolidated  financial  statements.  Additionally,  the
Borrowers  have notified the lenders that changing  market  conditions and other
factors will likely impact the  Borrowers'  ability to comply with the financial
covenants in future periods.  The Borrowers are evaluating various  cost-cutting
initiatives to improve  profitability,  but there can be no assurance that these
efforts will  generate  sufficient  liquidity to enable the  Borrowers to comply
with the  financial  covenants in future  periods.  The  Borrowers  are pursuing
discussions  with the  lenders in an effort to amend the New Palco Term Loan and
the New Palco  Revolving  Credit  Agreements  to reflect these  changing  market
conditions  and  other  factors;  however,  there can be no  assurance  that the
Borrowers will be successful in their  efforts.  In the event that the Borrowers
are unable to improve  profitability or amend the two facilities as needed, they
may be forced to take extraordinary actions.

     The New Palco  Term  Loan and New  Palco  Revolving  Credit  Facility  each
include prepayment  premiums of 3%, 2% and 1% that will be payable in connection
with any  prepayment of the New Palco Term Loan or reduction or  termination  of
the New Palco Revolving Credit Facility during the facilities' first, second and
third years, respectively. Under the New Palco Term Loan and New Palco Revolving
Credit Facility, Palco is permitted to invest up to $5.0 million in the Company.
No such investment has been made or committed to be made by Palco, and there can
be no assurance that Palco would in the future  determine or be able to make any
such investment in whole or part.

     Reclassifications

     Certain   reclassifications  have  been  made  to  prior  years'  financial
statements to be consistent with the current year's  presentation.

     Use of Estimates and Assumptions

     The  preparation  of financial  statements  in accordance  with  accounting
principles  generally  accepted in the United States of America requires the use
of  estimates  and  assumptions   that  affect  (i)  the  reported  amounts  and
classification  of assets and  liabilities  (ii) the  disclosure  of  contingent
assets and  liabilities  known to exist as of the date the financial  statements
are published and (iii) the reported amount of revenues and expenses  recognized
during each period  presented.  The Company  reviews all  significant  estimates
affecting its consolidated financial statements on a recurring basis and records
the effect of any necessary adjustments prior to filing the financial statements
with the Securities and Exchange Commission. Adjustments made to estimates often
relate to improved  information  not  previously  available.  Uncertainties  are
inherent in such estimates and related assumptions;  accordingly, actual results
could differ from these estimates.

     Risks and  uncertainties  are inherent with respect to the ultimate outcome
of the  matters  discussed  in Note  5.  The  results  of a  resolution  of such
uncertainties  could have a material effect on the Company's financial position,
results of operations or liquidity.

2.   New Accounting Standards

     Exchanges of Nonmonetary Assets
     In December  2004,  the FASB issued SFAS No. 153.  SFAS No. 153 is based on
the principle that  exchanges of nonmonetary  assets should be measured based on
the fair value of the assets exchanged.  The adoption of SFAS No. 153 on January
1, 2006, did not have an impact on the Company's financial statements.

     Accounting Changes and Error Corrections
     In May 2005, the FASB issued SFAS No. 154,  which changes the  requirements
applicable to accounting for and reporting of a change in accounting  principle.
SFAS No.  154  requires  retrospective  application  of a change  in  accounting
principle to prior periods' financial statements,  unless it is impracticable to
determine  either the  period-specific  effects or the cumulative  effect of the
change.  SFAS No. 154 is effective for  accounting  changes and  corrections  of
errors made in fiscal years  beginning  after December 15, 2005. The adoption of
SFAS No.  154 on  January  1,  2006,  did not have an  impact  on the  Company's
financial statements.

     Fair Value Measurements
     In  September  2006,  the FASB issued  SFAS No.  157,  which is intended to
increase  consistency and  comparability in fair value  measurements by defining
fair value,  establishing  a framework  for  measuring  fair value and expanding
disclosures about fair value  measurements.  SFAS 157 is effective for financial
statements  issued for fiscal years  beginning  after  November  15,  2007,  and
interim  periods  within those fiscal years.  The Company will adopt SFAS 157 on
January 1, 2008, and has not yet determined the impact, if any, on its financial
statements.

3.   Restricted  Cash,  Cash  Equivalents,   Marketable   Securities  and  Other
     Investments

     Restricted  cash,  cash  equivalents,   marketable   securities  and  other
investments  include the following  amounts which are restricted under the terms
of the Company's debt agreements (in millions):

                                                                                      September 30,   December 31,
                                                                                           2006           2005
                                                                                     --------------- ----------------
Amounts held in the SAR Account:
  Current portion of restricted marketable securities and other investments          $   8.9         $    23.0
  Long-term portion of restricted marketable securities and other investments (1)       41.3              52.9
  Less:  Amounts attributable to Timber Notes held in SAR Account (1)                  (41.3)            (52.9)
                                                                                     --------------- ----------------
    Total amounts held in the SAR Account                                                8.9              23.0

Other amounts restricted under the Timber Notes Indenture                                4.3               2.5
                                                                                     --------------- ----------------
Total restricted cash, cash equivalents, marketable securities and other investments $  13.2         $    25.5
                                                                                     =============== ================
------------------------

(1)  This amount  represents the aggregate  amount price paid by the Company for
     the Class A-1 and Class A-2 Timber Notes held in the SAR Account. The Class
     A-2 Timber Notes held in the SAR Account were sold in October 2006, and the
     net proceeds from the sale of approximately $30.2 million were deposited in
     the SAR Account.

     Amounts in the SAR  Account,  including  the  Timber  Notes held in the SAR
Account,  are being held by the  Trustee to support  principal  payments  on the
Timber Notes. See Note 4 for further discussion of the SAR Account.

4.   Debt

     Principal  amounts  of  outstanding  debt  consist  of  the  following  (in
millions):

                                                                                      September 30,   December 31,
                                                                                           2006           2005
                                                                                     --------------- ----------------
Line of Credit, due as described below                                                $   47.8       $         31.3
6.55% Class A-1 Timber Notes due July 20, 2028                                             7.3                 36.6
7.11% Class A-2 Timber Notes due July 20, 2028                                           243.2                243.2
7.71% Class A-3 Timber Notes due July 20, 2028                                           463.3                463.3
                                                                                     --------------- ----------------
    Total Principal Outstanding                                                          761.6                774.4
    Less: Current Maturities                                                             (81.6)               (60.5)
       Class A-1 Timber Notes held in the SAR Account, at par value(1)                    (2.8)               (13.9)
       Class A-2 Timber Notes held in the SAR Account, at par value(1) (2)               (41.5)               (41.5)
                                                                                     --------------- ----------------
                                                                                      $  635.7       $        658.5
                                                                                      ============== ================
-----------------------
(1)  The Timber Notes Indenture provides that a Timber Note does not cease to be
     outstanding  because the Company holds the  instrument.  Consequently,  the
     Company is  required  to pay and has paid  interest  and  principal  on the
     Timber Notes held in the SAR Account.
(2)  The Class A-2  Timber  Notes held in the SAR  Account  were sold in October
     2006.

     Line of Credit
     The Line of Credit  allows the Company to borrow up to one year's  interest
on the aggregate  outstanding  principal balance of the Timber Notes. On May 18,
2006, the Line of Credit was extended to July 6, 2007. At or near the completion
of such  extension,  the Company  intends to request  that the Line of Credit be
extended for an  additional  period of not less than 364 days.  If not extended,
the Company may draw upon the full amount available.  The amount drawn would, to
the extent of available  funds,  be repayable in 12 semiannual  installments  on
each  Timber  Notes  payment  date (after the  payment of certain  other  items,
including the Aggregate Minimum Principal  Amortization Amount, as defined, then
due), commencing  approximately two and one-half years following the date of the
draw. At September 30, 2006, the maximum  availability  under the Line of Credit
was $53.5 million, and outstanding borrowings were $47.8 million.

     Timber Notes
     On the Timber  Notes  payment  date in January  2006,  the Company used its
existing cash resources,  all of the remaining funds available under the Line of
Credit,  and the additional funds made available from a $2.3 million  timber/log
purchase by MGI, to pay all of the $27.7 million of interest due ($25.8  million
net of interest  due in respect of Timber  Notes held in the SAR  Account).  The
Company  also repaid  $19.3  million of  principal  on the Timber  Notes  ($11.9
million net of principal in respect of Timber Notes held in the SAR Account), an
amount equal to Scheduled Amortization, using funds held in the SAR Account.

     On the  Timber  Notes  payment  date in July  2006,  the  Company  used its
existing cash resources,  all of the remaining funds available under the Line of
Credit,  $10.2  million  of funds  from the Land Sale  Program,  a $3.7  million
timber/log purchase by MGI, and a $2.1 million early log payment by Palco to pay
all of the $27.1  million of interest due ($25.4  million net of interest due in
respect of Timber Notes held in the SAR Account).  The Company also repaid $10.0
million of  principal  on the Timber  Notes ($6.2  million net of  principal  in
respect of Timber Notes held in the SAR  Account),  an amount equal to Scheduled
Amortization, using funds held in the SAR Account.

     As  discussed  further  in Note 1, the  Company is  experiencing  financial
difficulties due to regulatory restrictions on harvesting, and other factors. As
a result,  the Company expects to incur substantial  interest payment shortfalls
over at least the next several years. Such an event would constitute an event of
default  under the  Timber  Notes  Indenture.  In the event of a failure  to pay
interest or  principal  on the Timber Notes in full when due, the Trustee or the
holders of at least 25% of the  aggregate  outstanding  principal  amount of the
Timber Notes may cause all principal,  interest and other amounts related to the
Timber  Notes to become  immediately  due and payable.  Also,  in the event of a
failure  by the  Company  or  Palco  to  perform  its  respective  covenants  or
agreements  under the  Master  Purchase  Agreement  or by Palco to  perform  its
covenants or agreements under the Services Agreement,  which failure in the case
of certain  covenants or agreements  continues for 30 days after notice from the
Trustee or the holders of 25% or more of the outstanding principal amount of the
Timber Notes, the holders of a majority of the aggregate  outstanding  principal
amount of the Timber Notes may cause all  principal,  interest and other amounts
related to the Timber Notes to become immediately due and payable.  In the event
of any such acceleration, the Agent under the Line of Credit may also accelerate
the advances  then  outstanding.  If such  accelerations  of Timber Notes and/or
advances  under the Line of Credit  occur,  the Trustee may  exercise all rights
under the Timber  Notes  Indenture  and related  security  documents,  including
applying funds to pay accelerated  amounts,  and selling the Company Timberlands
and the Company Timber Rights and other assets and using the proceeds thereof to
pay accelerated  amounts.  In the event that the Company were to seek protection
by filing under the  Bankruptcy  Code,  all amounts  related to the Timber Notes
would become  immediately  due and payable under the Timber Notes  Indenture and
all advances under the Line of Credit could be accelerated. The foregoing rights
of the Trustee and holders of Timber Notes would be subject to the rights of the
Company under the  Bankruptcy  Code if it sought  protection by filing under the
Bankruptcy Code.

     U.S. Bank, the Trustee under the Timber Notes Indenture, resigned effective
May 1, 2006.  The Company  appointed  Deutsche  Bank  National  Trust Company as
successor  Trustee under the Timber Notes Indenture,  which  appointment  became
effective May 1, 2006.  Deutsche Bank National Trust Company resigned  effective
August 25, 2006 and the Company appointed Bank of New York as successor Trustee,
which appointment became effective August 25, 2006.

     SAR Account
     Amounts on deposit in the SAR Account are used on each Timber Notes payment
date to make principal payments on the Timber Notes in accordance with Scheduled
Amortization.  However,  if the amount on deposit in the SAR Account on a Timber
Notes payment date is less than what is needed to reduce  outstanding  principal
in accordance with Scheduled Amortization, only the amount on deposit in the SAR
Account is required to be paid as a principal payment on the Timber Notes.

     At  September  30,  2006,  the  SAR  Account   balance  was  $50.2  million
(consisting  of $41.3  million of Timber  Notes held in the SAR Account and $8.9
million in marketable securities).  On October 11, 2006, the Company completed a
private  placement of the $41.5 million par value of Class A-2 Timber Notes held
in the SAR Account at a sales price of $750 per $1,000  principal  amount,  plus
accrued  interest from July 20, 2006.  The net proceeds of  approximately  $30.2
million were deposited into the SAR Account.  The Company  expects that cash and
marketable  securities  on deposit in the SAR Account will not be  sufficient to
cover all of the Scheduled  Amortization  on the January 20, 2008,  Timber Notes
payment date and beyond.

5.   Regulatory and Environmental Factors and Contingencies

     Regulatory and Environmental Factors
     Regulatory and environmental  matters and litigation have had a significant
adverse  effect on the  Company's  business,  which is  subject  to a variety of
California and federal laws and  regulations,  as well as the HCP,  dealing with
timber harvesting  practices,  threatened and endangered species and habitat for
such species, air and water quality and other matters. Compliance with such laws
and regulations also plays a significant role in the Company's business.

     Environmental Plans
     From March 1999 until October 2002, the Company prepared THPs in accordance
with the  SYP.  The SYP was  intended  to  comply  with  regulations  of the CDF
requiring  timber  companies to  demonstrate  sustained  yield,  i.e. that their
projected  average  annual  harvest  for any decade  within a 100-year  planning
period  would not  exceed  the  average  annual  growth  level at the end of the
100-year planning period.  These regulations allow companies which do not have a
sustained  yield plan to follow  alternative  procedures to document  compliance
with   the   sustained   yield    requirements.    As   discussed   below   (see
"-Contingencies-Timber  Harvest  Litigation"),  in October 2003,  the California
trial court hearing the EPIC-SYP/Permits lawsuit entered a judgment invalidating
the SYP and the California  Permits,  although an appellate  court reversed that
decision in  December  2005.  The  plaintiffs  appealed  the  appellate  court's
decision to the California Supreme Court, which has indicated it will review the
matter. As a result of an earlier stay order and the trial court's judgment, the
Company from October 2002 until March 2005  obtained  review and approval of its
THPs under an  alternative  procedure in the  California  forest  practice rules
known as Option C. Option C is available  to  landowners  who have  submitted an
"Option A" plan to the CDF for review (as was done by Palco). An approved Option
A plan is an  alternative to obtaining  approval of a sustained  yield plan. The
Company's  Option A plan was  approved by the CDF in March 2005.  The Company is
currently  relying  upon the  Option A Plan to obtain  THP  approvals,  and will
likely continue to do so in the future.

     The Federal Permits allow  incidental  "take" of certain  federally  listed
species located on the Company  Timberlands so long as there is no "jeopardy" to
the continued  existence of such species.  The HCP identifies the measures to be
instituted  in order to minimize and mitigate the  anticipated  level of take to
the greatest  extent  practicable.  The HCP and Federal Permits have terms of 50
years.  Since the consummation of the Headwaters  Agreement in March 1999, there
has  been a  significant  amount  of  work  and  additional  costs  required  in
connection with the implementation of the Environmental Plans, and this work and
the additional costs are expected to continue for the foreseeable future.

     Water Quality
     Laws and  regulations  dealing with water  quality are  impacting the Palco
Companies primarily in four areas:  efforts by the EPA and the North Coast Water
Board to establish  TMDLs in  watercourses  that have been  declared to be water
quality  impaired;  actions  by the North  Coast  Water  Board to  impose  waste
discharge  reporting  requirements  in  respect  of  watersheds  on the  Company
Timberlands and in some cases,  clean-up or preventive measures;  actions by the
North  Coast  Water  Board  during the THP  approval  process  imposing  certain
operational requirements on individual THPs; and the development of WWDRs by the
North  Coast  Water  Board  and its  staff  for  the  Freshwater  and Elk  River
watersheds.

     Under the CWA, the EPA is required to establish TMDLs in watercourses  that
have been declared to be "water  quality  impaired." The EPA and the North Coast
Water  Board  are in  the  process  of  establishing  TMDLs  for  many  northern
California rivers and certain of their tributaries,  including nine watercourses
that flow  within the  Company  Timberlands.  On the  Company  Timberlands,  the
relevant  contaminant  is  simple  sediment  - dust,  dirt and  gravel - that is
abundant  in  watercourses  largely as a function of the area's  normally  heavy
rainfall  and soil that  erodes  easily.  The  Company  expects  the  process of
establishing  TMDLs to continue  until at least 2010. The EPA has issued reports
dealing with TMDLs on three of the nine  watercourses.  The agency has indicated
that the  requirements  under the HCP would  significantly  address the sediment
issues that resulted in TMDL requirements for these watercourses. Presently, the
North Coast Water Board is in the process of establishing the TMDL  requirements
applicable to two other  watercourses,  Freshwater and Elk River, on the Company
Timberlands, with a targeted completion of 2007 for these two watercourses.  The
Company's  scientists are actively working with North Coast Water Board staff to
ensure that these TMDLs recognize and incorporate the  environmental  protection
measures  of the HCP.  The final TMDL  requirements  applicable  to the  Company
Timberlands may require aquatic  protection  measures that are different from or
in  addition to those in the HCP or that  result  from the  prescriptions  to be
developed  pursuant to the watershed  analysis  process provided for in the HCP.
Those requirements could further restrict harvesting on the Company Timberlands.

     For each of the winter  periods since 2002, the Company and Palco have been
required to submit reports on sediment  discharges and erosion control practices
to the North Coast Water Board in order to conduct winter harvesting  operations
in the  Freshwater  and Elk  River  watersheds.  After  consideration  of  these
reports, the North Coast Water Board imposed requirements on the Palco Companies
to  implement  additional  mitigation  and erosion  control  practices  in these
watersheds  for each of these winter  operating  periods.  The North Coast Water
Board has also  extended the  requirements  for certain  mitigation  and erosion
control practices to three additional watersheds (Bear, Jordan and Stitz Creek).
The Palco Companies and the North Coast Water Board are currently in discussions
to determine what these measures will be. The requirements  imposed to date have
significantly  increased operating costs;  future additional  requirements could
further increase costs and cause additional delays in THP approvals.

     The North Coast Water Board has also issued the Elk River Orders, which are
aimed at addressing  existing sediment production sites through cleanup actions.
The North Coast Water Board has also  initiated the process that could result in
similar  orders  for  the  Freshwater   and  Bear  Creek   watersheds,   and  is
contemplating similar actions for the Jordan and Stitz Creek watersheds. The Elk
River Orders have resulted in increased costs that could extend over a number of
years.  Additional orders for other watersheds  (should they be issued) may also
result in further cost  increases.

     On May 8, 2006,  the North Coast Water Board adopted the Freshwater and Elk
River WWDRs.  The  decision  allows  harvesting  in these two  watersheds,  up to
approximately  50% of the applicable  CDF Harvest  Limit,  once the staff of the
North Coast Water Board reviews and enrolls THPs  submitted by the Company.  The
North Coast Water  Board's  decision  also allowed the  enrollment of additional
THPs, bringing the total to approximately 75% of the CDF Harvest Limit for these
two  watersheds,  upon  approval of a monitoring  and  reporting  program by the
Executive  Officer of the North Coast  Water Board  staff.  The  monitoring  and
reporting program was approved on September 29, 2006, allowing enrollment by the
staff of the  North  Coast  Water  Board of the  additional  THPs for  these two
watersheds  planned for harvest in 2006. This  monitoring and reporting  program
will also govern future THPs in these two watersheds.  However,  there can be no
assurance  that  additional  THPs in these two  watersheds  will  ultimately  be
enrolled or harvested as planned in 2006 or future years.  The North Coast Water
Board's  adoption of these WWDRs has been appealed to the State Water Board, but
the appeals are being held in abeyance in order to see how the implementation of
the WWDRs proceeds.  As harvesting  activities on the Company Timberlands cannot
readily be moved between watersheds due to, among other things, historic harvest
patterns,  adjacency restrictions,  and the age classes of trees, development of
WWDRs and the various other matters  described  herein are expected to result in
reduced harvest levels in 2006 and beyond.

     Effective  January 1, 2004,  California  Senate Bill 810 provides  regional
water quality control boards with additional  authority  related to the approval
of THPs on land within  impaired  watersheds.  The Company is  uncertain  of the
operational and financial  effects that will ultimately  result from Senate Bill
810;  however,  because  substantially all rivers and waterbodies on the Company
Timberlands  are  classified as  sediment-impaired,  implementation  of this law
could result in additional delays in obtaining  approvals of THPs, lower harvest
levels,  increased  costs,  and  additional  protection  measures  beyond  those
contained in the HCP.

     Contingencies

     Various  pending  judicial  and  administrative  proceedings,  as described
below,  could affect the  Company's  and Palco's  ability to implement  the HCP,
implement  certain  approved THPs, or carry out other  operations.  The Services
Agreement  requires  Palco to  prepare  and file on  behalf of the  Company  (at
Palco's  cost) all  pleadings  and motions,  and  otherwise  diligently  pursue,
appeals of any denial,  and defense of any challenge to approval,  of any THP or
the Environmental Plans or similar plan or permit and related matters.

     In March 1999, the EPIC-SYP/Permits lawsuit was filed. This action alleged,
among other things,  various violations of the California Endangered Species Act
and the  California  Environmental  Quality  Act,  and  challenged,  among other
things,  the validity and legality of the SYP and the  California  Permits,  and
sought,  among  other  things,  to prevent  implementation  of THPs  approved in
reliance upon these documents.  A similar action, the USWA lawsuit, was filed on
the same day, and the two actions were consolidated for trial.

     Following  the  trial,  the  Court  in  October  2003  entered  a  judgment
invalidating the SYP and the California  Permits,  and in September 2004 granted
the  plaintiffs'  request for  reimbursement  of an aggregate of $5.8 million in
attorneys'  fees and  other  expenses.  The  Palco  Companies  and the  State of
California  appealed both  decisions.  On December 12, 2005, an appellate  court
reversed the trial  court's  decision  invalidating  the SYP and the  California
Permits.  The  plaintiffs  have appealed the appellate  court's  decision to the
California  Supreme  Court,  which has indicated it will review the matter.  The
defendants' appeal of the trial court's award of attorneys' fees and expenses is
still pending at the appellate court. There can be no assurance that this appeal
will be successful.

     In July 2001, the Bear Creek lawsuit was filed and later amended to add the
EPA as a defendant.  The lawsuit  alleges  that  harvesting  and other  forestry
activities  under  certain of the  Company's  THPs will result in  discharges of
pollutants in violation of the CWA. The plaintiff  asserts that the CWA requires
the  defendants  to obtain a permit  from the North  Coast  Water  Board  before
beginning timber harvesting and road  construction  activities and is seeking to
enjoin these activities until such permit has been obtained.  The plaintiff also
seeks  civil  penalties  of up to  $27,500  per day for  the  alleged  continued
violation of the CWA. In October  2003,  the Court upheld the validity of an EPA
regulation  that exempts  harvesting and other forestry  activities from certain
discharge  requirements.  Both state and federal agencies,  along with Palco and
other timber companies, have relied upon this regulation for more than 25 years.
However,  the Court  interpreted  the  regulation in such a way as to narrow the
forestry  operations  that  are  exempted,  thereby  limiting  the  regulation's
applicability and subjecting culverts and ditches to permit  requirements.  This
ruling has widespread implications for the timber industry in the United States.
The case is not yet final as the trial has not yet been held, and there are many
unresolved  issues  involving  interpretation  of the Court's  decision  and its
application to actual  operations.  On April 28, 2006, the Court denied separate
motions for summary  judgment that had been filed by the Palco Companies and the
plaintiff.  On June 30, 2006, the plaintiff  filed a motion for partial  summary
judgment  seeking to  establish  the Palco  Companies'  liability  and the Palco
Companies filed a new motion for summary  judgment  asserting that the plaintiff
lacks  standing to maintain the lawsuit.  A hearing on these motions was held on
October 3, 2006, and the Court took the matter under submission.

     Should the Court's  October 2003  decision  ultimately  become final and be
held to apply to all of the timber  operations  of the Palco  Companies,  it may
have  some  or all of the  following  effects:  imposing  additional  permitting
requirements,  delaying  approvals of THPs,  increasing  harvesting  costs,  and
adding water protection  measures beyond those contained in the HCP. The Company
believes that civil penalties should not be awarded for operations that occurred
prior to the Court's decision due to timber companies'  historical reliance upon
the regulation and the Company's belief that the requirements  under the HCP are
adequate to ensure that sediment and pollutants  from  harvesting  activities on
the Company Timberlands will not reach levels harmful to the environment.  While
the impact of a conclusion to this case that upholds the October 2003 ruling may
be adverse,  the Company  does not  believe  that such an outcome  should have a
material  adverse  impact  on the  Company's  financial  condition,  results  of
operations  or  liquidity.  Nevertheless,  due to the numerous ways in which the
Court's  interpretation of the regulation could be applied to actual operations,
there can be no assurance that this will be the case.

     On November 20, 2002, the Cook and Cave actions were filed,  which name the
Company and certain  affiliates as defendants.  The Cook action  alleges,  among
other things, that defendants' logging practices have contributed to an increase
in flooding along Freshwater Creek (which runs through the Company Timberlands),
resulting  in  personal  injury  and  damage  to  the  plaintiffs'   properties.
Plaintiffs  further  allege that in order to have THPs  approved in the affected
areas,  the  defendants  engaged  in  certain  unfair  business  practices.  The
plaintiffs  seek,  among  other  things,  compensatory  and  exemplary  damages,
injunctive relief, and appointment of a receiver to ensure that the watershed is
restored.  The Cave action contains  similar  allegations  and requests  similar
relief with respect to the Elk River  watershed (a portion of which is contained
on the Company  Timberlands).  On October 13, 2005, the Johnson action was filed
and contains  allegations similar to the Cave and Cook actions. The Company does
not believe the resolution of these actions should result in a material  adverse
effect on its financial condition, results of operations or liquidity.

     On February 25, 2003,  the District  Attorney of Humboldt  County filed the
Humboldt DA action. The suit was filed under California's unfair competition law
and alleges that the Palco Companies used certain unfair  business  practices in
connection with completion of the Headwaters  Agreement,  and that this resulted
in the harvest of  significantly  more trees than would have  otherwise been the
case. The suit sought a variety of remedies, including a civil penalty of $2,500
for each  additional tree that has been or will be harvested due to this alleged
increase in harvest,  as well as restitution and an injunction in respect of the
additional  timber harvesting  allegedly being conducted.  On June 14, 2005, the
Court dismissed this matter in its entirety. On September 19, 2005, the District
Attorney  appealed  this  decision,  however,  the  Company  believes  that  the
dismissal and prior rulings of the Court  substantially  diminished the exposure
of the Palco Companies with respect to this matter.

     In December  2005,  the Company and Palco filed the  California  Headwaters
action with the Claims Board. The California  Headwaters action alleges that the
defendants have  substantially  impaired the contractual and legal rights of the
Company  and Palco  under the  Headwaters  Agreement  and the  related  permits,
authorizations and approvals. The California Headwaters action also alleges that
the actions of the defendants have caused the companies substantial damages, but
does not  specify an amount.  While the Claims  Board has  indicated  that it is
investigating  the  matter,  it  failed  to  approve  or deny  the  claim by the
statutory  deadline.  As a  result,  the  California  Headwaters  action  is  by
operation  of law treated as having been  denied,  the Company and Palco may now
file a claim for damages in  California  state court.  The Company and Palco are
considering how best to proceed with respect to this matter.

     The Company is involved in other claims,  lawsuits and  proceedings.  While
uncertainties  are  inherent  in the final  outcome  of such  matters  and it is
presently  impossible  to  determine  the actual  costs that  ultimately  may be
incurred or their effect on the Company, management believes that the resolution
of such  uncertainties  and the  incurrence of such costs should not result in a
material  adverse  effect  on the  Company's  financial  condition,  results  of
operations or liquidity.

6.   Comprehensive Income (Loss) and Member Deficit

     Comprehensive income (loss) includes the following (in millions):

                                                                        Three Months                Nine Months
                                                                    Ended September                 Ended
                                                                          30,                   September 30,
                                                                ------------------------- --------------------------
                                                                    2006         2005         2006         2005
                                                                ------------ ------------- ------------ -------------

Net income (loss)                                               $    4.9     $    1.2      $   (8.1)    $  (11.2)
Other comprehensive income:
  Net change in fair value of available-for-sale investments           -            -             -          0.2
                                                                ------------ ------------- ------------ -------------
Total comprehensive income (loss)                                $   4.9     $    1.2      $   (8.1)    $  (11.0)
                                                                ============ ============= ============ =============

     A  reconciliation  of the  activity  in member  deficit is as  follows  (in
millions):
                                                                                              Nine Months Ended
                                                                                                September 30,
                                                                                          --------------------------
                                                                                              2006          2005
                                                                                          ------------ -------------
Balance at beginning of period                                                            $   (444.5)  $    (431.6)
Comprehensive loss                                                                              (8.1)        (11.0)
                                                                                          ------------ -------------
Balance at end of period                                                                  $   (452.6)  $    (442.6)
                                                                                          ============ =============

ITEM 2. MANAGEMENT'S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
     OF OPERATIONS

     The following should be read in conjunction  with the financial  statements
in Part I,  Item 1 of this  Report  and  Item 7.  "Management's  Discussion  and
Analysis  of  Financial  Condition  and  Results  of  Operations"  and  Item  8.
"Financial  Statements and Supplementary Data" of the Form 10-K. Any capitalized
terms used but not defined in this Item are defined in the  "Glossary of Defined
Terms"  contained in Appendix A. Except as otherwise  noted,  all  references to
Notes represent the Condensed Notes to Financial Statements included herein.

     This Quarterly  Report on Form 10-Q contains  statements  which  constitute
"forward-looking  statements"  within the meaning of the PSLRA. These statements
appear in a number of places in this Report.  Such  statements can be identified
by the use of forward-looking  terminology such as "believes," "expects," "may,"
"estimates," "will," "should," "could," "plans," "intends," "projects," "seeks,"
or  "anticipates"  or the  negative  thereof  or  other  variations  thereon  or
comparable  terminology,  or by discussions  of strategy.  Readers are cautioned
that  any  such   forward-looking   statements  are  not  guarantees  of  future
performance and involve  significant  risks and  uncertainties,  and that actual
results may vary materially from the  forward-looking  statements as a result of
various  factors.  These  factors  include  the  effectiveness  of  management's
strategies and decisions, general economic and business conditions, developments
in  technology,   new  or  modified   statutory,   environmental  or  regulatory
requirements,   litigation   developments,   and  changing   prices  and  market
conditions.  This Form 10-Q and the Form 10-K identify other factors which could
cause differences between such forward-looking statements and actual results. No
assurance can be given that these are all of the factors that could cause actual
results to vary materially from the forward-looking statements.

Results of Operations

     This  section  contains   statements   which  constitute   "forward-looking
statements" within the meaning of the PSLRA. See the second paragraph of Item 2.
for cautionary information with respect to such forward-looking statements.

     The  Company's  business  has  become  increasingly  unpredictable  due  to
continued  regulatory  constraints,  ongoing  litigation  challenges  and  other
factors. Additionally, the Company's business is somewhat seasonal, with its net
sales having  historically  been higher in the months of April through  November
than in the  months of  December  through  March.  Management  expects  that the
Company's   revenues  and  cash  flows  will   continue  to  be   unpredictable.
Accordingly,  the  Company's  results for any one  quarter  are not  necessarily
indicative of results to be expected for the full year.

     Regulatory and environmental  matters as well as legal actions have had and
are expected to continue to adversely affect the Company's operations.  See Item
1.  "Business-Regulatory and Environmental Factors," and Item 1A. "Risk Factors"
of the Form  10-K and in this  Form  10-Q and Note 5 for  information  regarding
these matters.  Regulatory compliance and related litigation have caused and are
expected  to  continue  to  cause  delays  in  approval  of THPs and  delays  in
harvesting on THPs once they are approved.  This has resulted and is expected to
continue to result in a significant decline in harvest and increased costs.

     Management  has concluded  that, in the absence of  significant  regulatory
relief and  accommodations,  the Company's annual timber harvest levels and cash
flows from  operations  will for at least several years be  substantially  below
both historical  levels and the minimum levels necessary to allow the Company to
satisfy its debt  service  obligations  in respect of the Timber  Notes.  To the
extent that the Company is unable to generate sufficient liquidity from the Land
Sale  Program or other  sources,  the Company  expects that it will be forced to
take extraordinary  actions, which may include:  laying off employees,  shutting
down various  operations,  and seeking protection by filing under the Bankruptcy
Code.

     In addition to the matters described above,  there can be no assurance that
certain other pending  legal,  regulatory  and  environmental  matters or future
governmental  regulations,   additional  litigation,  legislation,  judicial  or
administrative  decisions,  adverse  weather  conditions,  or low  lumber or log
prices,  will not also have material adverse effects on the Company's  financial
condition,  results of operations or liquidity. See Item 1. "Business-Regulatory
and Environmental Factors," and Item 3. "Legal Proceedings" of the Form 10-K and
Item 1A.  "Risk  Factors"in  this  Form 10-Q and Note 5 (under  "Regulatory  and
Environmental  Factors"  and  "Contingencies  Timber  Harvest  Litigation")  for
further  information  regarding  regulatory  and  legislative  matters and legal
proceedings relating to the Company's operations.

     Log Sales to Palco
     The following  table  presents  price,  volume and revenue  amounts for the
Company for the periods indicated (revenues in millions).

                                     Three Months Ended September 30, 2006   Three Months Ended September 30, 2005
                                     -------------------------------------- -----------------------------------------
                                                      Price                                  Price
                                         MBFE        $/MBFE       Revenues       MBFE       $/MBFE      Revenues
                                     ----------- ------------- ------------ ------------- ------------- -------------
Redwood                                20,400    $   1,004     $    20.5        21,900    $    952      $     20.8
Douglas fir                             4,500          616           2.8         7,200         640             4.7
Other                                     900          391           0.3           600         404             0.2
                                     -----------               ------------ -------------                -------------
                                       25,800          916     $    23.6        29,700         865      $     25.7
                                     ===========               ============ =============                =============

                                      Nine Months Ended September 30, 2006   Nine Months Ended September 30, 2005
                                     -------------------------------------------------------------------------------
                                                     Price                                   Price
                                         MBFE        $/MBFE       Revenues       MBFE       $/MBFE      Revenues

                                     ----------- ------------- ------------- ------------ ------------- -------------
Redwood                                41,800    $     993     $    41.5        55,000    $    892      $     49.0
Douglas fir                             7,600          614           4.7        16,200         605             9.9
Other                                   1,300          381           0.4         1,700         189             0.3
                                     -----------               ------------- ------------               -------------
                                       50,700          921     $    46.6        72,900         812         $  59.2
                                     ===========               ============= ============               =============

     For the three months ended  September 30, 2006, the Company  experienced an
overall 8.2% decrease in revenues and a 13.1% decrease in sales volume  compared
to the three  months  ended  September  30,  2005.  The  decrease  in revenue is
attributable  to the  decline  in  harvest  levels,  partially  offset by a 5.9%
increase in the average realized price of logs.

     For the nine months ended  September 30, 2006,  the Company  experienced an
overall 21.3% decrease in revenues and a 30.5% decrease in sales volume compared
to the nine  months  ended  September  30,  2005.  The  decrease  in  revenue is
attributable  to the  decline in  harvest  levels,  partially  offset by a 13.4%
increase in the average realized price of logs.

     Operating Income and Net Loss
     The Company  generated  operating income of $18.7 million and $33.2 million
for the third  quarter of 2006 and the nine months  ended  September  30,  2006,
respectively.  These  results  include a gain of $4.1 million and $9.1  million,
respectively,  from the sale of  certain  properties.  The  Company's  operating
results for the first nine months of 2005  include  substantial  legal and other
professional  fees  relating  to the  Company's  efforts to pursue a  negotiated
restructuring  of the Timber  Notes.  The  Company  also had excess cash in 2005
invested that generated equity income of approximately $1.0 million in the third
quarter of 2005 and $2.1 million for the nine months ended September 30, 2005.

Financial Condition and Investing and Financing Activities

     This  section  contains   statements   which  constitute   "forward-looking
statements" within the meaning of the PSLRA. See the second paragraph of Item 2.
for cautionary information with respect to such forward-looking statements.

     Due to its highly leveraged  condition,  the Company is more sensitive than
less leveraged companies to factors affecting its operations,  including low log
prices,  governmental  regulation and  litigation  affecting  timber  harvesting
operations on the Company  Timberlands  (see Item 1A. "Risk Factors" of the Form
10-K and in this Form 10-Q and Note 5), and  general  economic  conditions.  The
Company's  cash flows from  operations  are  significantly  impacted  by harvest
volumes and log prices.  The Master Purchase  Agreement  between the Company and
Palco (see Item 1. "Business-Operation of Company Timberlands" of the Form 10-K)
contemplates  that all  sales of logs by the  Company  to Palco  will be at fair
market value (based on stumpage prices) for each species and category of timber.
The Master  Purchase  Agreement  provides  that if the purchase  price equals or
exceeds  the SBE Price and a  structuring  price set forth in a schedule  to the
Timber Notes Indenture, the purchase price is deemed to be at fair market value.
If the  purchase  price  equals or exceeds  the SBE Price,  but is less than the
structuring  price,  then the  Company  is  required  to engage  an  independent
forestry  consultant  to confirm that the purchase  price  reflects  fair market
value. In January 2006, the State Board of Equalization  adopted the new Harvest
Value Schedule for the first half of 2006. The prices published in that schedule
reflected  a 9.7%  increase in the SBE Price for small  redwood  logs and a 5.6%
decrease for small Douglas-fir logs from the prices published for the first half
of 2005. In June 2006, the State Board of Equalization  issued the Harvest Value
Schedule  for the second half of 2006.  The prices  published  in that  schedule
reflected  a 4.0%  increase in the SBE Price for small  redwood  logs and a 5.6%
decrease  for small  Douglas fir logs from the prices  published  for the second
half of 2005.

     Future Harvest Levels
     The Company has  conducted  extensive  reviews and  analyses of its assets,
operations  and future  prospects.  As a result of these  extensive  reviews and
analyses,  the  Company  has  concluded  that,  in the  absence  of  significant
regulatory  relief and  accommodations,  its future annual timber harvest levels
and cash  flows  from  operations  for at least the next  several  years will be
substantially  below  both  historical  harvest  levels and the  minimum  levels
necessary  in order  to allow it to  satisfy  its debt  service  obligations  in
respect of the Timber  Notes.  The Company  has  previously  disclosed  that its
estimated  average annual harvest levels over the ten-year  period  beginning in
2006 is  estimated to be  approximately  100 million  board feet per year.  This
harvest  level  reflects  the  Company's  estimate of the  cumulative  impact of
ongoing regulatory limitations, watershed prescriptions, the requirements of the
HCP and other  matters and is based on a number of  assumptions  that may or may
not prove to be accurate.  Actual harvest levels may even be lower, depending on
the outcome of various assumptions.

     Regulatory Matters
     Regulatory and environmental  matters as well as legal actions have had and
are expected to continue to have a significant  adverse  effect on the Company's
operations and liquidity. The ability to harvest Company Timber depends in large
part upon the Company's ability to obtain  regulatory  approval of its THPs. The
Company has experienced  difficulties  and delays in the approval of its THPs as
the result of regulatory and litigation  challenges and expects these challenges
to  persist.  The  foregoing  matters  have  resulted  in declines in actual and
expected  harvest  levels and cash flows,  significant  increases in the cost of
logging operations and increased costs related to timber harvest litigation, all
of which have severely  impacted the  historical  cash flows of both the Company
and Palco. These adverse effects are expected to continue.

     The North  Coast Water  Board is  requiring  the Company and Palco to apply
various waste discharge  reporting,  mitigation and erosion control requirements
in respect of timber harvesting activities in several watersheds,  and is likely
to impose  additional  measures  in the  future.  The North Coast Water Board in
December 2003 directed its staff to formulate  WWDRs for the  Freshwater and Elk
River  watersheds  on the  Company  Timberlands.  THPs in these  two  watersheds
represent a significant  portion of the harvest planned in 2006 and for the next
several years.

     On May 8, 2006,  the North Coast Water Board adopted the Freshwater and Elk
River WWDRs.  The decision  allows  harvesting  in these two  watersheds,  up to
approximately  50% of the applicable  CDF Harvest  Limit,  once the staff of the
North Coast Water Board reviews and enrolls THPs  submitted by the Company.  The
North Coast Water  Board's  decision  also allowed the  enrollment of additional
THPs, bringing the total to approximately 75% of the CDF Harvest Limit for these
two  watersheds,  upon  approval of a monitoring  and  reporting  program by the
Executive  Officer of the North Coast  Water Board  staff.  The  monitoring  and
reporting program was approved on September 29, 2006, allowing enrollment by the
staff of the  North  Coast  Water  Board of the  additional  THPs for  these two
watersheds  planned for harvest in 2006. This  monitoring and reporting  program
will also govern future THPs in these two watersheds.  However,  there can be no
assurance  that  additional  THPs in these two  watersheds  will  ultimately  be
enrolled or harvested as planned in 2006 or future years.  The North Coast Water
Board's  adoption of these WWDRs has been appealed to the State Water Board, but
the appeals are being held in abeyance in order to see how the implementation of
the WWDRs proceeds.  As harvesting  activities on the Company Timberlands cannot
readily be moved between watersheds due to, among other things, historic harvest
patterns,  adjacency restrictions,  and the age classes of trees, development of
WWDRs and the various other matters  described  herein are expected to result in
reduced harvest levels in 2006 and beyond.

     Liquidity Update
     In the absence of significant  regulatory  relief and  accommodations,  the
Company's  annual timber harvest levels and cash flows from operations will, for
at least the next several years, be substantially  below both historical  levels
and the  minimum  levels  necessary  to allow the  Company to  satisfy  its debt
service obligations in respect of the Timber Notes.

     In an effort to address the expected  future interest  payment  shortfalls,
the  Company  initiated  the  Land  Sale  Program  to  sell  certain  timberland
properties, as well as various non-timberland properties, such as ranchlands and
recreational  areas. The Company expects that all of the net proceeds from sales
under the Land Sale  Program  will be  available  to pay  interest on the Timber
Notes,  in  accordance  with the Timber Notes  Indenture.  During the first nine
months of 2006,  the Company  sold  properties  available  under the program for
$13.1 million.  The aggregate estimated market value of the remaining properties
included in the Land Sale Program  should cover the  Company's  expected  future
interest payment shortfalls, and the sale of enough of these properties to cover
the expected future interest  payment  shortfalls  should not materially  reduce
estimated  average annual  harvest levels over the next decade.  There can be no
assurance that the marketing  efforts for the Land Sale Program  properties will
be  successful  or that the  resulting  proceeds,  if any, will be sufficient to
cover the Company's expected future interest payment shortfalls.  The properties
included in the Land Sale Program may change from time to time.

     In an effort to address the Company's 2006 operating cash  shortfalls,  the
Company and MGI consummated three timber/log purchases that provided the Company
an  aggregate  of $8.1  million of  additional  liquidity  to pay its  expenses,
including  interest  due in  respect of the  Timber  Notes on the  Timber  Notes
payment dates in January 2006 and July 2006, as discussed  below.  In July 2006,
the Company also requested that Palco make an early payment of $2.1 million,  in
respect of certain  logs that had already  been  delivered  to and  purchased by
Palco from the  Company.  Palco  approved and  delivered  the early log payment,
which  was  used to pay the  Company's  expenses,  including  a  portion  of the
interest due in respect of the July 2006 Timber Notes payment date.

     On the Timber  Notes  payment  date in January  2006,  the Company used its
existing cash resources,  all of the remaining funds available under the Line of
Credit,  and the additional funds made available from a $2.3 million  timber/log
purchase by MGI, to pay all of the $27.7 million of interest due ($25.8  million
net of interest  due in respect of Timber  Notes held in the SAR  Account).  The
Company  also repaid  $19.3  million of  principal  on the Timber  Notes  ($11.9
million net of principal in respect of Timber Notes held in the SAR Account), an
amount equal to Scheduled Amortization, using funds held in the SAR Account.

     On the  Timber  Notes  payment  date in July  2006,  the  Company  used its
existing cash resources,  all of the remaining funds available under the Line of
Credit,  $10.2  million  of funds  from the Land Sale  Program,  a $3.7  million
timber/log  purchase by MGI, and the $2.1 million  early log payment by Palco to
pay all of the $27.1 million of interest due ($25.4  million net of interest due
in respect of Timber  Notes held in the SAR  Account).  The Company  also repaid
$10.0 million of principal on the Timber Notes ($6.2 million net of principal in
respect of Timber Notes held in the SAR  Account),  an amount equal to Scheduled
Amortization, using funds held in the SAR Account.

     As noted above,  the Company also expects to continue to incur  substantial
interest payment shortfalls over at least the next several years. The failure of
the  Company  to pay all of the  interest  on the  Timber  Notes  when due would
constitute an event of default under the Timber Notes Indenture. There can be no
assurance  that  the  Company  will be able to  generate  sufficient  additional
liquidity to fund the expected  future cash  shortfalls.  To the extent that the
Company is unable to generate sufficient liquidity from the Land Sale Program or
other sources,  the Company expects that it will be forced to take extraordinary
actions,  which  may  include:  laying  off  employees,  shutting  down  various
operations, and seeking protection by filing under the Bankruptcy Code.

     Palco Liquidity Update
     As of December 31, 2005, and June 30, 2006, Palco and Britt were in default
under the Old Palco Term Loan and the Old Palco Revolving Credit Facility due to
financial covenant breaches. In the first half of 2006, additional liquidity was
needed at Palco and Palco  borrowed an  aggregate  of $20.0  million from MGI to
meet its cash shortfalls.  Palco's liquidity shortfalls during the first half of
2006 resulted primarily from reduced log supply from the Company and operational
inefficiencies  related  to the  large log  processing  line at  Palco's  Scotia
sawmill.

     On July 18, 2006,  Palco and Britt,  as Borrowers,  closed on the New Palco
Term Loan,  a  five-year  $85.0  million  secured  term loan,  and the New Palco
Revolving  Credit  Facility,  a  five-year  $60.0  million  secured  asset-based
revolving  credit  facility,  and  terminated  the Old  Palco  Revolving  Credit
Facility  and the Old Palco Term Loan.  The New Palco Term Loan was fully funded
at closing.  The New Palco Term Loan and the New Palco Revolving Credit Facility
required  MGI to provide a $10.0  million  subordinated  loan to the  Borrowers,
which was also funded at closing.  The Borrowers  used  approximately  (i) $34.0
million  of the New Palco  Term Loan to pay off the Old Palco  Term  Loan;  (ii)
$22.5  million  of the New Palco  Term  Loan to pay off the Old Palco  Revolving
Credit Facility and cash  collateralize  previously-existing  letters of credit;
and (iii) $6.0 million to pay transaction  costs. The remaining $32.5 million of
loan  proceeds  were used for general  corporate  purposes.  As of September 30,
2006, $84.6 million was outstanding under the New Palco Term Loan, $10.8 million
was outstanding  under the New Palco Revolving Credit Facility,  and the maximum
remaining  availability  under the New Palco Revolving Credit Facility was $36.5
million.

     The amount  available for borrowings  under the New Palco Revolving  Credit
Facility  is  normally  the  sum  of 85% of  the  Borrowers'  eligible  accounts
receivable  plus the lesser of (i) 80% of the book value of Borrowers'  eligible
inventory or (ii) 85% of the net orderly  liquidation  value of such  inventory.
However,  during  each  period  from  October 15 through  January 15, the amount
available for borrowing under the New Palco Revolving Credit Facility is the sum
of 95% of Borrowers'  eligible accounts receivable plus the lesser of (i) 90% of
the book value of Borrowers'  eligible  inventory or (ii) 95% of the net orderly
liquidation  value of such inventory.  The amount  available under the New Palco
Revolving  Credit Facility may not exceed $60.0 million,  subject to limitations
such as the ability of the lender to establish reasonable reserves.

     The New Palco Term Loan  bears  interest  at the rate of LIBOR plus  8.75%.
Loans under the New Palco Revolving Credit Facility bear interest at the rate of
LIBOR  plus  2.75% or prime  plus  0.75%,  at the  Borrowers'  option;  however,
incremental borrowings made during the period from October 15 through January 15
bear  interest  at the  rate of  LIBOR  plus  4.50%  or  prime  plus  2.50%,  as
applicable.

     Both the New Palco Term Loan and the New Palco  Revolving  Credit  Facility
contain substantially  identical restrictive covenants that limit the Borrowers'
ability to incur debt,  grant  liens,  make  investments,  pay  dividends,  make
capital  expenditures  or merge or  consolidate,  and require the  Borrowers  to
maintain  specified  minimum  levels  of  EBITDA  throughout  the  life  of  the
facilities  and  specified  minimum  fixed  charge  coverage  ratios and maximum
leverage ratios commencing  December 31, 2007. The operating cash flow estimates
used to  establish  the EBITDA  maintenance  covenant are subject to a number of
assumptions  about future  operating  cash flows and actual results could differ
materially  from  these  estimates.  The New Palco Term Loan also  requires  the
Borrowers to repay a substantial portion of the outstanding principal of the New
Palco  Term  Loan with the net  proceeds  from  various  required  asset  sales,
including the real property  associated with Palco's former Fortuna and Carlotta
sawmills,  and Palco-owned  homes to be sold after certain  milestones have been
met. Any  remaining  principal  balance of the New Palco Term Loan is due on the
maturity date. Accordingly,  continued compliance with these new debt facilities
is  dependent  on  Palco's  ability to meet its  EBITDA  projections  and timely
complete required asset sales. There can be no assurance that Palco will be able
to meet these financial covenants in future periods. The New Palco Term Loan and
the New Palco Revolving Credit Facility contain  customary events of default and
customary remedies with respect to the occurrence of an event of default and are
each  secured by a  security  interest  in the stock of Palco  held by MGI,  and
substantially  all of the assets of the  Borrowers  (other than  Palco's  equity
interest in the Company).

     The Borrowers did not meet the required minimum EBITDA maintenance covenant
for the three  month  period  ended  September  30,  2006,  due to an  unplanned
severance  charge and a legal  settlement.  The Borrowers  expect the lenders to
issue a limited waiver of the default through December 14, 2006. Until such time
as the default is resolved,  amounts  outstanding  under the New Palco Term Loan
and the New Palco  Revolving  Credit  Facility have been classified as a current
liability  in MAXXAM's  consolidated  financial  statements.  Additionally,  the
Borrowers  have notified the lenders that changing  market  conditions and other
factors will likely impact the  Borrowers'  ability to comply with the financial
covenants in future periods.  The Borrowers are evaluating various  cost-cutting
initiatives to improve  profitability,  but there can be no assurance that these
efforts will  generate  sufficient  liquidity to enable the  Borrowers to comply
with the  financial  covenants in future  periods.  The  Borrowers  are pursuing
discussions  with the  lenders in an effort to amend the New Palco Term Loan and
the New Palco  Revolving  Credit  Agreements  to reflect these  changing  market
conditions  and  other  factors;  however,  there can be no  assurance  that the
Borrowers will be successful in their  efforts.  In the event that the Borrowers
are unable to improve  profitability or amend the two facilities as needed, they
may be forced to take extraordinary actions.

     The New Palco  Term  Loan and New  Palco  Revolving  Credit  Facility  each
include prepayment  premiums of 3%, 2% and 1% that will be payable in connection
with any  prepayment of the New Palco Term Loan or reduction or  termination  of
the New Palco Revolving Credit Facility during the facilities' first, second and
third years, respectively. Under the New Palco Term Loan and New Palco Revolving
Credit Facility, Palco is permitted to invest up to $5.0 million in the Company.
No such investment has been made or committed to be made by Palco, and there can
be no assurance that Palco would in the future  determine or be able to make any
such investment in whole or part.

     In  addition to the  material  adverse  effects  being  experienced  by the
Company and Palco due to continuing  regulatory,  environmental  and  litigation
difficulties,  there can be no  assurance  that  certain  other  pending  legal,
regulatory  and  environmental  matters  or  future  governmental   regulations,
additional  litigation,   legislation,  judicial  or  administrative  decisions,
adverse  weather  conditions,  or low lumber or log  prices,  will not also have
material  adverse effects on the financial  condition,  results of operations or
liquidity of the Company's operations.  See Note 5 for further discussion of the
regulatory  and  environmental  matters  and  legal  proceedings  affecting  the
Company's operations.

     Other Matters
     Capital  expenditures  were $4.4  million for the first nine months of 2006
and are expected to be between  $3.5 million and $4.0 million for the  remainder
of 2006, subject to available cash.

Off-Balance Sheet Arrangements

     The  Company  does not have any  off-balance  sheet  financing,  other than
operating   leases   entered  into  in  the  normal   course  of  business,   or
unconsolidated  special purpose  entities.  The Company does not use derivatives
for any of its treasury or risk management activities.

Trends

     Harvest  levels at the Company are  expected to decline  significantly,  as
compared to historical  harvest levels, in 2006 and beyond.  Consequently,  cash
flows from the Company's operations will not be sufficient for at least the next
several  years to allow the Company to satisfy its debt service  obligations  in
respect  of its  Timber  Notes.  In an effort to address  expected  future  cash
shortfalls,  the Company is seeking to sell certain  timberland  properties,  as
well as various non-timberland  properties,  such as ranchlands and recreational
areas.  Although  certain sales have been  completed,  there can be no assurance
that the  marketing  efforts  in  respect of the  remaining  properties  will be
successful.

     Palco has  commenced  the Palco Asset Sale Program  pursuant to which it is
marketing certain assets. The New Palco Term Loan and New Palco Revolving Credit
Facility  require the Borrowers to complete  transactions  under the Palco Asset
Sale Program in accordance with certain established  deadlines.  There can be no
assurance  that these  marketing  efforts will be successful or that  regulatory
approvals  will be obtained to enable Palco to timely  complete  required  asset
sales.

     There has been a substantial  decline in the market  prices of  Douglas-fir
logs and lumber  and  Palco's  and  Britt's  future  operating  results  will be
negatively impacted by this development.

Critical Accounting Policies and Estimates

     See Item 7.  "Management's  Discussion and Analysis of Financial  Condition
and Results of  Operations--Critical  Accounting  Policies and Estimates" of the
Form 10-K for a discussion of the Company's critical accounting policies.  There
have been no material changes to the Company's critical  accounting policies and
estimates provided in the Form 10-K.

New  Accounting Pronouncements

     See Note 2 for a  discussion  of new  accounting  pronouncements  and their
impact on the Company's financial statements.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     The  Company is exposed to  changes  in  interest  rates  under the Line of
Credit.  As of  September  30,  2006,  there  were $47.8  million in  borrowings
outstanding  under  all  variable  rate  facilities.  Based  on  the  amount  of
borrowings  outstanding  under these facilities as of September 30, 2006, a 2.0%
change in interest  rates  effective  from the  beginning of the year would have
resulted in an  increase or decrease in interest  expense for the period of $0.5
million.

ITEM 4. CONTROLS AND PROCEDURES

     The Company maintains  disclosure controls and procedures that are designed
to ensure that  information  required to be disclosed in the  Company's  reports
under the Securities Exchange Act of 1934 is recorded, processed, summarized and
reported  within the time  periods  specified in the rules and forms of the SEC,
and that such  information  is  accumulated  and  communicated  to the Company's
management,  including its Chief Executive Officer and Chief Financial  Officer,
as appropriate,  to allow timely decisions  regarding  required  disclosure.  In
designing and  evaluating  the disclosure  controls and  procedures,  management
recognized  that any controls and  procedures,  no matter how well  designed and
operated, can provide only reasonable assurance of achieving the desired control
objectives,  and  management  necessarily  was required to apply its judgment in
evaluating the cost-benefit relationship of possible controls and procedures.

     As of the end of the period covered by this report,  our management carried
out an  evaluation,  under the  supervision  and with the  participation  of the
Company's management,  including our Chief Executive Officer and Chief Financial
Officer,  of the  effectiveness  of the design and  operation  of the  Company's
disclosure  controls and procedures.  Based on the  evaluation,  our management,
including our Chief  Executive  Officer and Chief Financial  Officer,  concluded
that the  Company's  disclosure  controls and  procedures  were  effective as of
September 30, 2006.

     There have been no significant  changes in the Company's  internal controls
or in other  factors  that  could  significantly  affect the  internal  controls
subsequent to the date the Company completed its evaluation.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

     The information set forth in Note 5 is incorporated herein by reference.

ITEM 1A. RISK FACTORS

     Part I, Item 1A of the Company's Form 10-K contains  important risk factors
that could cause the Company's  actual results to differ  materially  from those
projected in any forward-looking  statement.  Additional risks and uncertainties
not  currently  known or that are currently  deemed  immaterial  may  materially
adversely impact our business,  financial  condition or operating  results.  The
information presented below updates, and should be read in conjunction with, the
risk factor  information  disclosed in the Form 10 K for the year ended December
31, 2005.

     The Company has amended and  restated  the first item under "Risk  Factors:
Risks Related to Regulatory Matters" to read as follows:

     Regulatory  and  legislative  actions  have the power to limit our  harvest
levels and require us and Palco to incur additional costs and have other adverse
consequences.

      Regulatory and legislative actions, among others, are now having, or have
the potential to have, material adverse impacts on us and Palco:

     o    The North Coast Water Board has adopted WWDRs for the  Freshwater  and
          Elk River  watersheds.  This decision  allows  harvesting in these two
          watersheds  once THPs are  reviewed  and  enrolled by the staff of the
          North Coast Water Board.  In addition,  the  Executive  Officer of the
          North  Coast  Water  Board has  approved a  monitoring  and  reporting
          program,  which has the effect of allowing  enrollment by the staff of
          the  North  Coast  Water  Board  of  additional  THPs  for  these  two
          watersheds.  There  can  be no  assurance  that  THPs  for  these  two
          watersheds will ultimately be enrolled or harvested as planned in 2006
          or in future  years.  If there are delays in the  enrollment  of these
          THPs, there could be a further  significant  adverse impact on current
          and future  harvest  levels and the cash flows of both the Company and
          Palco.

     o    The final total maximum  discharge limits  requirements  applicable to
          the Company  Timberlands may require aquatic protection  measures that
          are  different  from or in addition to those in the HCP or that result
          from the watershed  analysis  process  provided for in the HCP.  These
          requirements   may  further  reduce  the  harvesting  on  the  Company
          Timberlands and cash flows of the Company and Palco.

     o    The North Coast Water Board has issued the Elk River Orders, which are
          aimed at addressing existing sediment production sites through cleanup
          actions in the Elk River  watershed,  and has  initiated  the  process
          which could  result in similar  orders for other  watersheds.  The Elk
          River Orders have resulted in increased costs that could extend over a
          number of years, and additional orders for other watersheds could have
          similar effects.

     o    The North  Coast  Water  Board has  imposed  requirements  for certain
          mitigation and erosion control practices in several  watersheds within
          the  Company  Timberlands.  The  requirements  imposed  to  date  have
          significantly   increased  operating  costs.  Additional  requirements
          imposed in the future could further increase costs and cause delays in
          THP approvals.

     o    The Company is uncertain of the operational and financial effects that
          will ultimately  result from Senate Bill 810, which provides  regional
          water quality control boards with additional  authority related to the
          approval of THPs on land within impaired watersheds. Implementation of
          this law could,  however,  result in delays in obtaining  approvals of
          THPs, lower harvest levels, increased costs, and additional protection
          measures beyond those contained in the HCP.

     o    The designation of a species as endangered or threatened under the ESA
          or the CESA can  significantly  reduce  harvest levels if that species
          inhabits  the  Company  Timberlands  or if the  habitat of the Company
          Timberlands is deemed  favorable to the species.  While the HCP covers
          17 different species,  it is possible that additional species could be
          designated as endangered or threatened under both the ESA and the CESA

     o    Laws,  regulations and related judicial  decisions and  administrative
          interpretations dealing with forest products operations are subject to
          change  and  new  laws  and  regulations  are  frequently   introduced
          concerning   the  California   timber   industry.   Moreover,   ballot
          initiatives  relating to the Company's  operations  are commenced from
          time to time.

     The Company has removed,  amended  and/or has added several new items under
"Risk Factors-Risks related to Our Liquidity and Capital Resources", as follows:

     The  Company's  annual  cash  flows  from  operations  are  expected  to be
substantially  below the minimum  levels  necessary  to satisfy its debt service
obligations over at least the next several years.

     The Company  expects  that its cash flows from  operations,  together  with
funds available under the Line of Credit, will be insufficient, by a substantial
amount, to pay the interest on the Timber Notes in 2007. The Company also expect
to incur principal and interest  shortfalls for at least the next several years.
Failure to pay interest on the Timber Notes when due would  constitute  an event
of default under the Timber Notes  Indenture.  We do not expect that the amounts
on deposit in the SAR Account as of the January 20, 2008,  Timber Notes  payment
date will be  sufficient to pay the Timber Notes in  accordance  with  Scheduled
Amortization.

     Amounts on deposit in the SAR  Account  will not be  sufficient  to pay the
Timber Notes in accordance with Scheduled Amortization in 2008 and beyond.

     Amounts on deposit in the SAR Account are used on each Timber Notes payment
date, as needed,  to make  principal  payments on the Timber Notes in accordance
with  Scheduled  Amortization.  If the amount on deposit in the SAR Account on a
Timber  Notes  payment  date is less than  what is needed to reduce  outstanding
principal in accordance with Scheduled Amortization,  only the amount on deposit
in the SAR Account is  required to be paid as a principal  payment on the Timber
Notes.

     The risk,  Palco is highly  leveraged and is currently in default under its
debt facilities, has been amended as follows:

     As noted elsewhere in this Form 10-Q, Palco and Britt expect the lenders to
issue a limited waiver through  December 14, 2006, of a default under their term
and revolving credit facilities. Unless the default is permanently waived or the
facilities  are amended,  or MGI  exercises  the right that it has under the two
facilities to cure the default,  the lenders would be entitled,  upon expiration
of the 30-day waiver period, to exercise a variety of rights and remedies,  such
as reducing  the amount of funds  available  for  borrowing  under the New Palco
Revolving  Credit  Facility,  declaring  any or all loans and other amounts owed
under the New Palco Term Loan and the New Palco Revolving  Credit Facility to be
immediately due and payable, and exercising all rights to collateral.

     The risk, Palco is highly leveraged and debt covenant restrictions increase
the difficulty of operating its business, has been added, as follows:

     Palco's  high level of debt and covenant  restrictions  under the New Palco
Term  Loan and New Palco  Revolving  Credit  Facility  could  have a variety  of
important negative consequences, including:

     o    limiting  Palco's  ability to borrow  additional  amounts  for working
          capital, capital expenditures, debt service requirements, execution of
          its operating strategies or other purposes;
     o    increasing  Palco's  vulnerability  to general  adverse  economic  and
          industry conditions;
     o    limiting Palco's ability to capitalize on business opportunities, such
          as purchasing  additional log inventories  from third parties,  and to
          react to competitive  pressures and adverse government  regulation and
          litigation developments; and
     o    limiting  Palco's  ability,  or increasing the costs, to refinance its
          indebtedness.

     The risk, Palco may not be able to timely complete required asset sales has
been added, as follows:

     Palco may not be able to complete  the Palco Asset Sale Program in a timely
manner.  Regulatory  approvals  required  to complete  the  program  could delay
receipt  of  liquidity  or  delay  certain  asset  sales  beyond  the  deadlines
established under Palco's new credit facilities.

     These risk factors and those set forth in the Form 10-K do not  represent a
comprehensive  list of factors that could cause our results to differ from those
that are currently anticipated and should be read together with the risk factors
and other  information  set forth in the Form  10-K and in the  Company's  other
filings with the Securities and Exchange Commission.

     ITEM 6. EXHIBITS

          a. Exhibits:

               *    31.1 Section 302 Certification of Chief Executive Officer

               *    31.2 Section 302 Certification of Chief Financial Officer

               *    32.1 Section 906 Certification of Chief Executive Officer

               *    32.2 Section 906 Certification of Chief Financial Officer

          *    Included with this filing

                             SIGNATURE

     Pursuant to the  requirements  of the Securities  Exchange Act of 1934, the
Registrant  has duly  caused  this  report  to be  signed  on its  behalf by the
undersigned  thereunto duly authorized,  who has signed this report on behalf of
the  Registrant  and as the principal  financial and  accounting  officer of the
Registrant.

                                         SCOTIA PACIFIC COMPANY LLC

Date: November 14, 2006             By:     /S/     GARY L. CLARK
                                        ----------------------------------
                                                    Gary L. Clark
                                     Vice President - Finance and Administration
                                              and Chief Financial Officer
                                    (Principal Financial and Accounting Officer)

                             APPENDIX A

                      Glossary of Defined Terms

APB Opinion No. 29:  Accounting  Principles  Board Opinion 29,  "Accounting  for
Nonmonetary Transactions"

Bankruptcy Code: The United States Bankruptcy Code

Bear Creek lawsuit:  An action  entitled  Environmental  Protection  Information
Association v. Pacific Lumber,  Scotia Pacific Company LLC (No.  C01-2821) filed
in the U.S. District Court for the Northern District of California

Britt: Britt Lumber Co., Inc., a wholly owned subsidiary of Palco

California  Permits:  The Permits issued by the State of California  pursuant to
the HCP

California  Headwaters action: The claim filed by the Company and Palco with the
Claims Board against the North Coast Water Board,  the State Water Board and the
State of  California  (Claim No.  G558159)  alleging  that the  defendants  have
substantially  impaired their  contractual and legal rights under the Headwaters
Agreement

California  Senate  Bill 810:  Bill  that  became  effective  January  1,  2004,
providing  regional  water  quality  control  boards with  additional  authority
related to the approval of THPs on land within impaired watersheds

Cave action:  An action  entitled Steve Cave, et al. v. Gary Clark,  et al. (No.
DR020719) filed in the Superior Court of Humboldt County, California

CDF: California Department of Forestry and Fire Protection

CDF Harvest Limit: Annual harvest limit established by the CDF

Claims Board: The California Victim Compensation and Government Claims Board

Company: Scotia Pacific Company LLC, a limited liability company wholly owned by
Palco

Company Timber: The timber located on the Company Timberlands.

Company  Timberlands:  Approximately  200,000 acres of timberlands  owned by the
Company and the timberlands subject to the Company Timber Rights

Company Timber Rights: The Company's exclusive right to harvest on approximately
12,200 acres of timberlands owned by Palco and Salmon Creek

Cook action:  An action  entitled Alan Cook,  et al. v. Gary Clark,  et al. (No.
DR020718) filed in the Superior Court of Humboldt County, California

CWA: Federal Clean Water Act

EBITDA:  As  defined  in  Section  1.01 of the New Palco Term Loan and New Palco
Revolving Credit Agreement  which,  among other things,  excludes the results of
the Company.

     Elk River  Orders:  Clean up and  abatement  orders  issued to Palco by the
North Coast Water Board for the Elk River watershed

Environmental Plans: The HCP and the SYP

EPA: Federal Environmental Protection Agency

EPIC-SYP/Permits   lawsuit:   An  action   entitled   Environmental   Protection
Information  Association,  Sierra Club v. California  Department of Forestry and
Fire  Protection,  California  Department of Fish and Game,  The Pacific  Lumber
Company,  Scotia Pacific Company LLC, Salmon Creek Corporation,  et al. filed in
the Superior Court of Humboldt County, California (No. CV990445)

FASB: Financial Accounting Standards Board

Federal Permits:  The Permits issued by the federal  government  pursuant to the
HCP

Form 10-K:  Annual  Report on Form 10-K of the Company for the fiscal year ended
December 31, 2005

Harvest Value Schedule:  A schedule  setting forth SBE Prices which is published
biannually  by the  California  State  Board of  Equalization  for  purposes  of
computing yield taxes on timber sales

HCP: The habitat  conservation  plan covering multiple species approved in March
1999 in connection with the consummation of the Headwaters Agreement

Headwaters Agreement:  The agreement among the Company, Palco, Salmon Creek, the
United States and California  pursuant to which the Palco Companies  transferred
to the United States  government 5,600 acres of timberlands in exchange for $300
million,  approximately  7,700  acres of  timberlands,  and  federal  and  state
government-approved habitat conservation and sustained yield plans

Humboldt DA action:  A civil suit entitled The People of the State of California
v. Pacific Lumber,  Scotia Pacific Holding Company and Salmon Creek  Corporation
(No.  DR030070) filed in the Superior Court of Humboldt County,  California,  by
the District Attorney of Humboldt County

Johnson action: An action entitled Edyth Johnson,  et al. v. Charles E. Hurwitz,
an individual, MAXXAM Inc., et al. (No. DR040720) filed in the Superior Court of
Humboldt County, California

Land Sale Program: The Company's program pursuant to which it is seeking to sell
certain timberland and non-timberland properties

Line of  Credit:  The  agreement  between  a group of  lenders  and the  Company
pursuant  to which  the  Company  may  borrow  in order to pay up to one  year's
interest on the Timber Notes

Master  Purchase  Agreement:  The  agreement  between the Company and Palco that
governs all purchases of logs by Palco from the Company

MAXXAM: MAXXAM Inc.

Mbfe: A concept  developed for use in structuring  the Timber Notes;  under this
concept one thousand  board feet,  net  Scribner  scale,  of old growth  redwood
timber equates to one Mbfe

MGHI: MAXXAM Group Holdings Inc., a wholly owned subsidiary of MAXXAM

MGI: MAXXAM Group Inc., an indirect wholly owned subsidiary of MGHI

New Palco  Revolving  Credit  Facility:  The new five-year $60.0 million secured
asset-based   revolving  credit  facility  evidenced  by  the  Revolving  Credit
Agreement dated as of July 18, 2006,  among Palco and Britt,  as borrowers,  and
Marathon Structured Finance Fund L.P., as amended

New Palco Term Loan: The new five-year $85.0 million secured term loan evidenced
by the Term Loan Agreement dated as of July 18, 2006,  among Palco and Britt, as
borrowers, and Marathon Structured Finance Fund L.P., as amended

North Coast Water Board: California North Coast Regional Water Quality Control Board

Old Palco Revolving Credit Facility:  Revolving credit facility evidenced by the
Revolving  Credit Agreement dated as of April 19, 2005 among Palco and Britt, as
Borrowers, and Credit Suisse First Boston

Old  Palco  Term  Loan:  $35.0  million  term  loan  evidenced  by the Term Loan
Agreement  dated as of April 19, 2005 among Palco and Britt,  as Borrowers,  and
The CIT Group/Business Credit, Inc.

Option  A  Plan:   Plan  for  complying  with   California's   sustained   yield
requirements,  which has been approved by the CDF and is being used by the Palco
Companies

Palco: The Pacific Lumber Company, a wholly owned subsidiary of MGI

Palco Asset Sale Program: Palco's process for marketing certain of its assets

Palco Companies: The Company, Palco, and Salmon Creek, collectively

Permits:  The incidental take permits issued by the United States and California
pursuant to the HCP

PSLRA: Private Securities Litigation Reform Act of 1995

Salmon Creek: Salmon Creek LLC, a wholly owned subsidiary of Palco

SAR Account:  Reserve account titled the Scheduled  Amortization Reserve Account
that holds funds used to support principal payments on the Timber Notes

State Board of Equalization: The California State Board of Equalization

SBE Price:  The applicable  stumpage price for a particular  species and size of
log, as set forth in the most recent Harvest Value Schedule

Scheduled  Amortization:  The amount of  principal  which the  Company  must pay
through each Timber Note payment date in order to avoid prepayment or deficiency
premiums

SEC: The Securities and Exchange Commission

Services  Agreement:  Agreement  between the Company and Palco under which Palco
provides  certain  operational,  management and related  services to the Company
with respect to the Company Timberlands

SFAS: Statement of Financial Accounting Standards

SFAS No. 153: SFAS No. 153,  "Exchange of  Nonmonetary  Assets," an amendment of
APB Opinion No. 29

SFAS No. 154: SFAS No. 154, "Accounting Changes and Error Correction"

SFAS No. 157: SFAS No. 157, "Fair Value Measurements"

State Water Board: California State Water Resources Control Board

State Water Board Order: Order issued by the State Water Board on June 16, 2005

SYP: The sustained  yield plan approved in March 1999 as part of the  Headwaters
Agreement, and later invalidated by a California state court

take:  Adverse  impacts on species  which have been  designated as endangered or
threatened

THP:  Timber  harvesting  plan required to be filed with and approved by the CDF
prior to the harvesting of timber

Timber  Notes:  The  Company's  6.55%  Series B Class A-1 Timber  Collateralized
Notes, 7.11% Series B Class A-2 Timber  Collateralized  Notes and 7.71% Series B
Class A-3 Timber Collateralized Notes due July 20, 2028

Timber Notes Indenture: The indenture governing the Timber Notes

TMDLs: Total maximum daily load limits

Trustee: The trustee under the Timber Notes Indenture

USWA lawsuit: An action entitled United Steelworkers of America,  AFL-CIO,  CLC,
and Donald Kegley v. California Department of Forestry and Fire Protection,  The
Pacific Lumber Company,  Scotia Pacific Company LLC and Salmon Creek Corporation
(No. CV990452) filed in the Superior Court of Humboldt County, California WWDRs:
Watershed-wide discharge requirements
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