UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 WASHINGTON,
D. C. 20549
 
 FORM
10-Q
 
 (Mark
One)
 [X]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
 SECURITIES
EXCHANGE ACT OF 1934
 For
the quarterly period ended June 30, 2008
 
 OR
 
 [   ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
 SECURITIES
EXCHANGE ACT OF 1934
 
 Commission
file number001-13255
 
 SOLUTIA
INC.
 (Exact
name of registrant as specified in its charter)
 
 DELAWARE
              43-1781797(State
      or other jurisdiction of incorporation or organization)
              (I.R.S. Employer Identification
      No.)
 
 575 MARYVILLE CENTRE
      DRIVE, P.O. BOX 66760, ST. LOUIS, MISSOURI
              63166-6760(Address
      of principal executive offices)
              (Zip
      Code)
 
 (314)
674-1000
 (Registrant’s
telephone number, including area code)
 
 Indicate by check mark whether the
registrant (1) has filed all reports to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding twelve 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.  YesX
No
 
 Indicate by check mark whether the
registrant is a large accelerated filer, an accelerated filer or a
non-accelerated filer.  See definition of “accelerated filer” and
“large accelerated filer” in Rule 12b-2 of the Exchange Act (Check
one):
 
 Large Accelerated Filer
___  Accelerated Filer X
Non-Accelerated Filer ___.
 
 Indicate by check mark whether the
registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act).  Yes
NoX
 
 Indicate the number of shares
outstanding of each of the issuer’s classes of common stock, as of the latest
practicable date.
 
 Class
              Outstanding
      at
                June 30,
      2008Common Stock, $0.01
      par value
              61,369,996
      shares
  
  PART
I. FINANCIAL INFORMATION
 
 Item
1.  FINANCIAL STATEMENTS
 
 SOLUTIA
INC.
 
 CONSOLIDATED
STATEMENT OF OPERATIONS
 (Dollars
and shares in millions, except per share amounts)
 (Unaudited)
 
 Successor
              
              
              PredecessorThree
      Months
                Ended
                June
      30,
                2008
              
              
              Three
      Months
                Ended
                June
      30,
                2007Net
      Sales
              
              $
              1,095
              
              
              $
              911Cost
      of goods sold
              
              
              986
              
              
              
              787Gross
      Profit
              
              
              109
              
              
              
              124Selling,
      general and administrative expenses
              
              
              80
              
              
              
              67Research,
      development and other operating expenses, net
              
              
              3
              
              
              
              3Operating
      Income
              
              
              26
              
              
              
              54Equity
      earnings from affiliates
              
              
              --
              
              
              
              3Interest
      expense (a)
              
              
              (48
              )
              
              
              (31
              )Other
      income, net
              
              
              6
              
              
              
              25Loss
      on debt modification
              
              
              --
              
              
              
              --Reorganization
      items, net
              
              
              --
              
              
              
              (17
              )Income
      (Loss) from Continuing Operations Before Income Tax
Expense
              
              
              (16
              )
              
              
              34Income
      tax expense
              
              
              --
              
              
              
              7Income
      (Loss) from Continuing Operations
              
              
              (16
              )
              
              
              27Income
      from Discontinued Operations, net of tax
              
              
              --
              
              
              
              29Net
      Income (Loss)
              
              $
              (16
              )
              
              $
              56Basic
      and Diluted Income (Loss) per Share:Income
      (Loss) from Continuing Operations
              
              $
              (0.27
              )
              
              $
              0.26Income
      from Discontinued Operations
              
              
              --
              
              
              
              0.28Net
      Income (Loss)
              
              $
              (0.27
              )
              
              $
              0.54
 
 (a)
              Excludes
      Predecessor unrecorded contractual interest expense of $8 in the three
      months ended June 30, 2007.
 
 CONSOLIDATED
STATEMENT OF COMPREHENSIVE INCOME (LOSS)
 (Dollars
in millions)
 (Unaudited)
 
 Successor
              
              
              PredecessorThree
      Months
                Ended
                June
      30,
                2008
              
              
              Three
      Months
                Ended
                June
      30,
                2007Net
      Income (Loss)
              
              $
              (16
              )
              
              $
              56Other
      Comprehensive Income (Loss):Currency
      translation adjustments
              
              
              (1
              )
              
              
              3Unrealized
      gain on derivative instruments
              
              
              5
              
              
              
              --Amortization
      of prior service gain
              
              
              --
              
              
              
              (4
              )Amortization
      of actuarial loss
              
              
              --
              
              
              
              3Actuarial
      loss arising during the two months ended February 29, 2008, net of tax of
      $2
              
              
              --
              
              
              
              --Prior
      service gain arising during the two months endedFebruary
      29, 2008
              
              
              --
              
              
              
              --Fresh-start
      accounting adjustment
              
              
              --
              
              
              
              --Comprehensive
      Income (Loss)
              
              $
              (12
              )
              
              $
              58
 
 See
      accompanying Notes to Consolidated Financial
  Statements.
  1
  SOLUTIA
INC.
 
 CONSOLIDATED
STATEMENT OF OPERATIONS
 (Dollars
and shares in millions, except per share amounts)
 (Unaudited)
 
 Successor
              
              
              PredecessorFour
      Months
                Ended
                June
      30,
                2008
              
              
              Two
      Months
                Ended
                February
      29,
                2008
              
              
              Six
      Months
                Ended
                June
      30,
                2007Net
      Sales
              
              $
              1,427
              
              
              $
              653
              
              
              $
              1,613Cost
      of goods sold
              
              
              1,302
              
              
              
              555
              
              
              
              1,386Gross
      Profit
              
              
              125
              
              
              
              98
              
              
              
              227Selling,
      general and administrative expenses
              
              
              106
              
              
              
              51
              
              
              
              125Research,
      development and other operating expenses, net
              
              
              5
              
              
              
              5
              
              
              
              11Operating
      Income
              
              
              14
              
              
              
              42
              
              
              
              91Equity
      earnings from affiliates
              
              
              --
              
              
              
              --
              
              
              
              12Interest
      expense (a)
              
              
              (66
              )
              
              
              (21
              )
              
              
              (59
              )Other
      income, net
              
              
              6
              
              
              
              2
              
              
              
              29Loss
      on debt modification
              
              
              --
              
              
              
              --
              
              
              
              (7
              )Reorganization
      items, net
              
              
              --
              
              
              
              1,642
              
              
              
              (33
              )Income
      (Loss) from Continuing Operations Before Income Tax
Expense
              
              
              (46
              )
              
              
              1,665
              
              
              
              33Income
      tax expense
              
              
              --
              
              
              
              215
              
              
              
              14Income
      (Loss) from Continuing Operations
              
              
              (46
              )
              
              
              1,450
              
              
              
              19Income
      from Discontinued Operations, net of tax
              
              
              --
              
              
              
              --
              
              
              
              29Net
      Income (Loss)
              
              $
              (46
              )
              
              $
              1,450
              
              
              $
              48Basic
      and Diluted Income (Loss) per Share:Income
      (Loss) from Continuing Operations
              
              $
              (0.77
              )
              
              $
              13.88
              
              
              $
              0.18Income
      from Discontinued Operations
              
              
              --
              
              
              
              --
              
              
              
              0.28Net
      Income (Loss)
              
              $
              (0.77
              )
              
              $
              13.88
              
              
              $
              0.46
 
 (a)
              Excludes
      Predecessor unrecorded contractual interest expense of $5 in the two
      months ended February 29, 2008 and $16 in the six months ended June 30,
      2007.
 
 CONSOLIDATED
STATEMENT OF COMPREHENSIVE INCOME (LOSS)
 (Dollars
in millions)
 (Unaudited)
 
 Successor
              
              
              PredecessorFour
      Months
                Ended
                June
      30,
                2008
              
              
              Two
      Months
                Ended
                February
      29,
                2008
              
              
              Six
      Months
                Ended
                June
      30,
                2007Net
      Income (Loss)
              
              $
              (46
              )
              
              $
              1,450
              
              
              $
              48Other
      Comprehensive Income (Loss):Currency
      translation adjustments
              
              
              22
              
              
              
              32
              
              
              
              5Unrealized
      gain on derivative instruments
              
              
              4
              
              
              
              --
              
              
              
              --Amortization
      of prior service gain
              
              
              --
              
              
              
              (3
              )
              
              
              (8
              )Amortization
      of actuarial loss
              
              
              --
              
              
              
              2
              
              
              
              7Actuarial
      loss arising during the two months ended February 29, 2008, net of tax of
      $2
              
              
              --
              
              
              
              (64
              )
              
              
              --Prior
      service gain arising during the two months endedFebruary
      29, 2008
              
              
              --
              
              
              
              109
              
              
              
              --Fresh-start
      accounting adjustment
              
              
              --
              
              
              
              (30
              )
              
              
              --Comprehensive
      Income (Loss)
              
              $
              (20
              )
              
              $
              1,496
              
              
              $
              52
 
 See
      accompanying Notes to Consolidated Financial
  Statements.
  2
  SOLUTIA
INC.
 
 CONSOLIDATED
STATEMENT OF FINANCIAL POSITION
 (Dollars
in millions, except per share amounts)
 (Unaudited)
 
 Successor
              
              
              PredecessorJune
      30,
                2008
              
              
              December
      31,
                2007ASSETSCurrent
      Assets:Cash
      and cash equivalents
              
              $
              47
              
              
              $
              173Trade
      receivables, net of allowances of $0 in 2008 and $4 in
2007
              
              
              508
              
              
              
              448Miscellaneous
      receivables
              
              
              117
              
              
              
              133Inventories
              
              
              798
              
              
              
              417Prepaid
      expenses and other assets
              
              
              118
              
              
              
              53Assets
      of discontinued operations
              
              
              --
              
              
              
              7Total
      Current Assets
              
              
              1,588
              
              
              
              1,231Property, Plant and Equipment,net of accumulated depreciation of $34 in 2008 and $2,699 in
      2007
              
              
              1,472
              
              
              
              1,052Goodwill
              
              
              524
              
              
              
              149Identified Intangible
      Assets,net
              
              
              880
              
              
              
              58Other
      Assets
              
              
              259
              
              
              
              150Total
      Assets
              
              $
              4,723
              
              
              $
              2,640LIABILITIES
      AND SHAREHOLDERS’ EQUITY (DEFICIT)Current
      Liabilities:Accounts
      payable
              
              $
              421
              
              
              $
              343Accrued
      liabilities
              
              
              302
              
              
              
              296Short-term
      debt, including current portion of long-term debt
              
              
              35
              
              
              
              982Liabilities
      of discontinued operations
              
              
              --
              
              
              
              6Total
      Current Liabilities
              
              
              758
              
              
              
              1,627Long-Term
      Debt
              
              
              1,768
              
              
              
              359Postretirement
      Liabilities
              
              
              448
              
              
              
              80Environmental
      Remediation Liabilities
              
              
              296
              
              
              
              61Deferred
      Tax Liabilities
              
              
              242
              
              
              
              45Other
      Liabilities
              
              
              187
              
              
              
              141Liabilities
      Subject to Compromise
              
              
              --
              
              
              
              1,922Commitments
      and Contingencies (Note 10)Shareholders’ Equity
      (Deficit):Successor
      common stock at $0.01 par value; (500,000,000 shares authorized,
      61,369,996 shares issued
                and
      outstanding in 2008)
              
              
              1
              
              
              
              --Predecessor
      common stock at $0.01 par value; (600,000,000 shares authorized,
      118,400,635 shares issued
                and
      outstanding in 2007)
              
              
              --
              
              
              
              1Additional
      contributed capital
              
              
              1,043
              
              
              
              56Predecessor
      stock held in treasury, at cost, 13,941,057 shares in 2007
              
              
              --
              
              
              
              (251
              )Predecessor
      net deficiency of assets at spin-off
              
              
              --
              
              
              
              (113
              )Accumulated
      other comprehensive income (loss)
              
              
              26
              
              
              
              (46
              )Accumulated
      deficit
              
              
              (46
              )
              
              
              (1,242
              )Total
      Shareholders’ Equity (Deficit)
              
              
              1,024
              
              
              
              (1,595
              )Total
      Liabilities and Shareholders’ Equity (Deficit)
              
              $
              4,723
              
              
              $
              2,640
 
 See
accompanying Notes to Consolidated Financial Statements.
  3
 SOLUTIA
INC.
 CONSOLIDATED
STATEMENT OF CASH FLOWS
 (Dollars
in millions)
 (Unaudited)
 Successor
              
              
              PredecessorFour
      Months
                Ended
                June
      30,
                2008
              
              
              Two
      Months
                Ended
                February
      29,
                2008
              
              
              Six
      Months
                Ended
                June
      30,
                2007INCREASE
      (DECREASE) IN CASH AND CASH EQUIVALENTS
                OPERATING
      ACTIVITIES:Net
      income (loss)
              
              $
              (46
              )
              
              $
              1,450
              
              
              $
              48Adjustments
      to reconcile net income (loss) to net cash used in
    operations:Income
      from discontinued operations, net of tax
              
              
              --
              
              
              
              --
              
              
              
              (29
              )Depreciation
      and amortization
              
              
              47
              
              
              
              20
              
              
              
              53Revaluation
      of assets and liabilities, net of tax
              
              
              --
              
              
              
              (1,591
              )
              
              
              --Discharge
      of claims and liabilities, net of tax
              
              
              --
              
              
              
              100
              
              
              
              --Other
      reorganization items, net
              
              
              --
              
              
              
              52
              
              
              
              32Pension
      expense less than contributions
              
              
              (10
              )
              
              
              (18
              )
              
              
              (46
              )Other
      postretirement benefits expense less than contributions
              
              
              (1
              )
              
              
              (6
              )
              
              
              (21
              )Amortization
      of deferred credits
              
              
              (2
              )
              
              
              (1
              )
              
              
              (5
              )Amortization
      of deferred debt issuance costs
              
              
              6
              
              
              
              --
              
              
              
              1Deferred
      income taxes
              
              
              (10
              )
              
              
              4
              
              
              
              2Equity
      earnings from affiliates
              
              
              --
              
              
              
              --
              
              
              
              (12
              )Restructuring
      expenses and other (gains) charges
              
              
              72
              
              
              
              (2
              )
              
              
              (11
              )Gain
      on sale of assets
              
              
              (5
              )
              
              
              --
              
              
              
              (7
              )Changes
      in assets and liabilities:Income
      taxes payable
              
              
              8
              
              
              
              5
              
              
              
              6Trade
      receivables
              
              
              (25
              )
              
              
              (34
              )
              
              
              (98
              )Inventories
              
              
              (79
              )
              
              
              (66
              )
              
              
              (21
              )Accounts
      payable
              
              
              44
              
              
              
              41
              
              
              
              23Environmental
      remediation liabilities
              
              
              --
              
              
              
              (1
              )
              
              
              (1
              )Other
      assets and liabilities
              
              
              3
              
              
              
              (18
              )
              
              
              13Cash
      Provided by (Used in) Continuing Operations before Reorganization
      Activities
              
              
              2
              
              
              
              (65
              )
              
              
              (73
              )Reorganization
      Activities:Establishment
      of VEBA retiree trust
              
              
              --
              
              
              
              (175
              )
              
              
              --Establishment
      of restricted cash for environmental remediation and other legacy
      payments
              
              
              --
              
              
              
              (46
              )
              
              
              --Payment
      for allowed secured and administrative claims
              
              
              --
              
              
              
              (79
              )
              
              
              --Professional
      service fees
              
              
              (27
              )
              
              
              (31
              )
              
              
              (37
              )Other
      reorganization and emergence related payments
              
              
              --
              
              
              
              (17
              )
              
              
              (4
              )Cash
      Used in Reorganization Activities
              
              
              (27
              )
              
              
              (348
              )
              
              
              (41
              )Cash
      Used in Operations – Continuing Operations
              
              
              (25
              )
              
              
              (413
              )
              
              
              (114
              )Cash
      Provided by (Used in) Operations – Discontinued Operations
              
              
              --
              
              
              
              1
              
              
              
              (1
              )Cash
      Used in Operations
              
              
              (25
              )
              
              
              (412
              )
              
              
              (115
              )INVESTING
      ACTIVITIES:Property,
      plant and equipment purchases
              
              
              (45
              )
              
              
              (29
              )
              
              
              (71
              )Acquisition
      and investment payments
              
              
              (1
              )
              
              
              --
              
              
              
              (115
              )Restricted
      cash
              
              
              --
              
              
              
              --
              
              
              
              (7
              )Investment
      proceeds and property disposals
              
              
              47
              
              
              
              --
              
              
              
              13Cash
      Provided by (Used in) Investing Activities-Continuing
      Operations
              
              
              1
              
              
              
              (29
              )
              
              
              (180
              )Cash
      Provided by Investing Activities-Discontinued Operations
              
              
              --
              
              
              
              --
              
              
              
              54Cash
      Provided by (Used in) Investing Activities
              
              
              1
              
              
              
              (29
              )
              
              
              (126
              )FINANCING
      ACTIVITIES:Net
      change in lines of credit
              
              
              23
              
              
              
              --
              
              
              
              19Proceeds
      from long-term debt obligations
              
              
              --
              
              
              
              1,600
              
              
              
              75Net
      change in long-term revolving credit facilities
              
              
              (8
              )
              
              
              190
              
              
              
              (53
              )Proceeds
      from stock issuance
              
              
              --
              
              
              
              250
              
              
              
              --Proceeds
      from short-term debt obligations
              
              
              --
              
              
              
              --
              
              
              
              325Payment
      of short-term debt obligations
              
              
              --
              
              
              
              (966
              )
              
              
              (53
              )Payment
      of long-term debt obligations
              
              
              (26
              )
              
              
              (366
              )
              
              
              --Payment
      of debt obligations subject to compromise
              
              
              --
              
              
              
              (221
              )
              
              
              --Debt
      issuance costs
              
              
              (1
              )
              
              
              (136
              )
              
              
              (9
              )Cash
      Provided by Financing Activities
              
              
              (12
              )
              
              
              351
              
              
              
              304INCREASE
      (DECREASE) IN CASH AND CASH EQUIVALENTS
              
              
              (36
              )
              
              
              (90
              )
              
              
              63CASH
      AND CASH EQUIVALENTS:Beginning
      of period
              
              
              83
              
              
              
              173
              
              
              
              150End
      of period
              
              $
              47
              
              
              $
              83
              
              
              $
              213SUPPLEMENTAL
      DISCLOSURE OF CASH FLOW INFORMATION:Cash
      payments for interest
              
              $
              48
              
              
              $
              43
              
              
              $
              60Cash
      payments for income taxes
              
              
              6
              
              
              
              4
              
              
              
              10
  See
      accompanying Notes to Consolidated Financial
  Statements.
  4
 SOLUTIA
INC.
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
  1.  Background
 
 Nature
of Operations
 
 Solutia
Inc., together with its subsidiaries, is a global manufacturer and marketer of a
variety of high-performance chemical-based materials.  Solutia is a
world leader in performance films for laminated safety glass and after-market
applications; specialty products such as chemicals for the rubber industry, heat
transfer fluids and aviation hydraulic fluids; and an integrated family of nylon
products including high-performance polymers and fibers.
 
 Prior to
September 1, 1997, Solutia was a wholly-owned subsidiary of the former Monsanto
Company (now known as Pharmacia Corporation, a 100% owned subsidiary of Pfizer,
Inc.).  On September 1, 1997, Pharmacia distributed all of the
outstanding shares of common stock of Solutia as a dividend to Pharmacia
stockholders (the “Solutia Spinoff”).  As a result of the Solutia
Spinoff, on September 1, 1997, Solutia became an independent publicly held
company and its operations ceased to be owned by Pharmacia.
 
 Unless
the context requires otherwise, the terms “Solutia”, “Company”, “we”, and “our”
in this report refer to Solutia Inc. and its subsidiaries.  The
financial information set forth in this report, unless otherwise expressly set
forth or as the context otherwise indicates, reflects the consolidated results
of operations and financial condition of Solutia Inc. and its subsidiaries for
the periods following March 1, 2008 (“Successor”), and of Solutia Inc. and its
subsidiaries for the periods through February 29, 2008
(“Predecessor”).
 
 Emergence
from Chapter 11 Proceedings
 
 On
February 28, 2008 (the “Effective Date”), we consummated our reorganization
under Chapter 11 of the U.S. Bankruptcy Code (the “Bankruptcy Code”) and emerged
from bankruptcy pursuant to our Fifth Amended Joint Plan of Reorganization which
was confirmed by the U.S. Bankruptcy Court for the Southern District of New York
(the “Bankruptcy Court”) on November 29, 2007 (the “Plan”).  We
and our 14 U.S. subsidiaries (the "Debtors") had filed voluntary petitions for
Chapter 11 protection on December 17, 2003 (the “Chapter 11
Cases”).  Our subsidiaries outside the United States were not included
in the Chapter 11 filing.  The filing was made to restructure our balance
sheet, to streamline operations and to reduce costs, in order to allow us to
continue operations as a viable going concern.  The filing also was
made to obtain relief from the negative financial impact of liabilities for
litigation, environmental remediation and certain post-retirement benefits (the
"Legacy Liabilities") and liabilities under operating contracts, all of which
were assumed at the time of the Solutia Spinoff.
 
  On the
Effective Date, all of our existing shares of common stock (the “Old Common
Stock”) were canceled pursuant to the Plan.  We also issued the
following shares of common stock, par value $0.01 per share, (the “New
Common Stock”) of the newly reorganized Solutia in satisfaction of creditor
claims and stockholder interests:  (1) 29,024,446 shares of
New Common Stock to our general unsecured creditors and to noteholders who held
our then outstanding 7.375% Notes due October 15, 2027 and
6.72% Notes due October 15, 2037, 825,743 of which shares are
being held in a disputed claims reserve for the benefit of holders of disputed
claims whose claims are subsequently allowed and any shares left over after all
disputed claims have been resolved shall be distributed pro rata to holders of
allowed claims; (2) 1,221,492 shares of New Common Stock to fund a
retiree trust, which qualifies as a Voluntary Employees’ Beneficiary Association
(VEBA); (3) 597,186 shares of New Common Stock, representing 1% of the
total New Common Stock, to holders of at least 175 shares of the Old Common
Stock; (4) 15,916,059 shares of New Common Stock to general unsecured
creditors and noteholders pursuant to the creditor rights offering (the
“Creditor Rights Offering”); (5) 2,833,003 shares of New Common Stock
to the backstop investors (the “Backstop Investors”) in the Creditor Rights
Offering; (6) 7,667,523 shares of New Common Stock to holders of at
least 11 shares of Old Common Stock pursuant to an equity rights offering
(the “Equity Rights Offering”); and (7) 2,489,977 shares of New Common
Stock, representing the shares of New Common Stock that were unsubscribed for in
the Equity Rights Offering, to Monsanto Company (“Monsanto”).  The
total amount of the
  5
 SOLUTIA
INC.
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
  general
unsecured claims pool was approximately $820.  In addition, we issued
warrants (the “Warrants”) to purchase an aggregate of 4,481,250 shares of
New Common Stock to holders of Old Common Stock based on a holder’s pre-petition
stock ownership, provided that such holder held at least 24 shares of the
Old Common Stock.
 
  Subject
to the terms of the Warrant Agreement, Warrant holders are entitled to purchase
shares of New Common Stock at an exercise price of
$29.70 per share.  The Warrants have a five-year term and
will expire on February 27, 2013.  The Warrants may be exercised
for cash or on a net issuance basis.
 
 On the
Effective Date we entered into financing agreements to borrow up to $2.05
billion from a syndicate of lenders (the “Financing Agreements”).  The
Financing Agreements consist of (i) a $450 senior secured asset-based revolving
credit facility which is comprised of a U.S. Facility and a Belgium Facility
(“Revolver”), (ii) a $1.2 billion senior secured term loan facility (“Term
Loan”) and (iii) a $400 senior unsecured bridge facility
(“Bridge”).
  
 2.  Fresh
Start Consolidated Statement of Financial Position
 
 On the
Effective Date, we adopted fresh-start accounting in accordance with the
American Institute of Certified Public Accountants’ Statement of Position 90-7,
Financial Reporting by
Entities in Reorganization Under the Bankruptcy Code(“SOP 90-7”) as
amended by Financial Accounting Standards Board (“FASB”) Staff Position No. SOP
90-7-1, An Amendment of AICPA
Statement of Position 90-7.  This resulted in our becoming a
new reporting entity on March 1, 2008, which has a new capital structure, a new
basis in the identifiable assets and liabilities assumed and no retained
earnings or accumulated losses.  Accordingly, the Consolidated
Financial Statements on or after March 1, 2008 are not comparable to the
Consolidated Financial Statements prior to that date.
 
 Fresh-start
accounting reflects our value as determined in the confirmed
Plan.  Under fresh-start accounting, our asset values are re-measured
using fair value and are allocated in accordance with Statement of Financial
Accounting Standards (“SFAS”) No. 141, Business Combinations (“SFAS
No. 141”).  The excess of reorganization value over the fair value of
tangible and identifiable intangible assets is recorded as
goodwill.  In addition, fresh-start accounting also requires that all
liabilities, other than deferred taxes, should be stated at fair value or at the
present values of the amounts to be paid using appropriate market interest
rates.  Deferred taxes are determined in conformity with SFAS No. 109,
Accounting for Income Taxes(“SFAS No. 109”).
 
 To
facilitate the calculation of the enterprise value of the Successor, management
developed a set of financial projections using a number of estimates and
assumptions.  The enterprise value, and corresponding equity value,
was based on these financial projections in conjunction with various valuation
methods, including (i) a comparison of us and our projected performance to
comparable companies; (ii) a review and analysis of several recent transactions
of companies in similar industries to ours; and (iii) a calculation of the
present value of our future cash flows under our
projections.  Utilizing these methodologies, the enterprise value was
determined to be within a certain range and, using the mid-point of the range,
the equity value of the Successor was estimated to be $1.0 billion.  During
the second quarter of 2008, the allocation of goodwill and identified intangible
assets amongst our operating segments was updated as a result of net adjustments
in the fair values of our operating segments.  As a result, total goodwill
decreased $22.  The estimated equity value of the Successor remained
unchanged at $1.0 billion.
 
 All
estimates, assumptions, valuations, appraisals and financial projections,
including the fair value adjustments, the financial projections, the enterprise
value and equity value, are inherently subject to significant uncertainties and
the resolution of contingencies beyond our control.  Accordingly,
there can be no assurance that the estimates, assumptions, valuations,
appraisals and the financial projections will be realized and actual results
could vary materially.  In accordance with generally accepted
accounting principles, the preliminary allocation of the enterprise value is
subject to additional adjustment within one year after emergence from bankruptcy
when additional or improved information on valuations becomes
available.  We expect that adjustments to recorded fair values may
include those relating to: (i) completion of valuation reports associated with
tangible and identifiable intangible assets, (ii) deferred tax assets and
liabilities, which may be adjusted based upon additional information, including
adjustments to fair value estimates of underlying assets or liabilities and the
determination of cancellation of indebtedness income and (iii) adjustments to
recorded fair values and deferred tax assets and liabilities which could change
the amount of recorded goodwill, as well as the allocation of such goodwill to
reportable segments.
 
 6
 SOLUTIA
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
  The adjustments set forth
in the following Fresh Start Consolidated Statement of Financial Position in the
columns captioned “Effect of Plan” and “Revaluation of Assets and Liabilities”
reflect the effect of the consummation of the transactions contemplated by the
Plan, including the settlement of various liabilities, securities issuances,
incurrence of new indebtedness and cash payments, and the revaluation of our
assets and liabilities to reflect their fair value under fresh-start
accounting.  The adjustments resulted in a pre-tax net effect of
discharge of claims and liabilities of $(104) under the Plan and a gain of
$1,798 resulting from the revaluation of our assets and
liabilities.
 
 The
effects of the Plan and fresh-start accounting on our Consolidated Statement of
Financial Position at February 29, 2008 are as follows:
 
 Predecessor
              
              
              
              
              
              
              
              
              
              
              SuccessorFebruary
      29,
                2008
              
              
              Effect
      of
                Plan
              
              
              
              Revaluation
      of Assets and Liabilities
              
              
              
              March
      1,
                2008ASSETSCurrent
      Assets:Cash
      and cash equivalents
              
              $
              180
              
              
              $
              (97
              )
              (a)
              
              $
              --
              
              
              
              $
              83Trade
      receivables, net
              
              
              483
              
              
              
              --
              
              
              
              
              --
              
              
              
              
              483Miscellaneous
      receivables
              
              
              152
              
              
              
              (1
              )
              (a)
              
              
              (1
              )
              (d)
              
              
              150Inventories
              
              
              483
              
              
              
              --
              
              
              
              
              308
              
              (d)
              
              
              791Prepaid
      expenses and other assets
              
              
              68
              
              
              
              30
              
              (a)(b)
              
              
              (10
              )
              (d)
              
              
              88Assets
      of discontinued operations
              
              
              5
              
              
              
              --
              
              
              
              
              --
              
              
              
              
              5Total
      Current Assets
              
              
              1,371
              
              
              
              (68
              )
              
              
              
              297
              
              
              
              
              1,600Property,
      Plant and Equipment
              
              
              1,066
              
              
              
              --
              
              
              
              
              419
              
              (d)
              
              
              1,485Goodwill
              
              
              150
              
              
              
              --
              
              
              
              
              374
              
              (e)
              
              
              524Identified
      Intangible Assets, net
              
              
              57
              
              
              
              --
              
              
              
              
              824
              
              (d)
              
              
              881Other
      Assets
              
              
              150
              
              
              
              112
              
              (a)(b)
              
              
              2
              
              (d)
              
              
              264Total
      Assets
              
              $
              2,794
              
              
              $
              44
              
              
              
              $
              1,916
              
              
              
              $
              4,754LIABILITIES
      AND SHAREHOLDERS’ DEFICITCurrent
      Liabilities:Accounts
      payable
              
              $
              405
              
              
              $
              --
              
              
              
              $
              --
              
              
              
              $
              405Accrued
      liabilities
              
              
              288
              
              
              
              14
              
              (a)
              
              
              15
              
              (d)
              
              
              317Short-term
      debt, including current portion of long-term debt
              
              
              1,098
              
              
              
              (1,085
              )
              (b)
              
              
              --
              
              
              
              
              13Liabilities
      of discontinued operations
              
              
              5
              
              
              
              --
              
              
              
              
              --
              
              
              
              
              5Total
      Current Liabilities
              
              
              1,796
              
              
              
              (1,071
              )
              
              
              
              15
              
              
              
              
              740Long-Term
      Debt
              
              
              386
              
              
              
              1,410
              
              (b)
              
              
              --
              
              
              
              
              1,796Postretirement
      Liabilities
              
              
              86
              
              
              
              372
              
              (a)
              
              
              --
              
              
              
              
              458Environmental
      Remediation Liabilities
              
              
              60
              
              
              
              207
              
              (a)
              
              
              33
              
              (d)
              
              
              300Deferred
      Tax Liabilities
              
              
              47
              
              
              
              (10
              )
              (a)
              
              
              202
              
              (d)
              
              
              239Other
      Liabilities
              
              
              145
              
              
              
              34
              
              (a)
              
              
              5
              
              (d)
              
              
              184Total
      Liabilities not Subject to Compromise
              
              
              2,520
              
              
              
              942
              
              
              
              
              255
              
              
              
              
              3,717Liabilities
      Subject to Compromise
              
              
              1,962
              
              
              
              (1,962
              )
              (a)
              
              
              --
              
              
              
              
              --Shareholders’ Equity
      (Deficit):Successor
      common stock at $0.01 par value
              
              
              --
              
              
              
              1
              
              (c)
              
              
              --
              
              
              
              
              1Predecessor
      common stock at $0.01 par value
              
              
              1
              
              
              
              --
              
              
              
              
              (1
              )
              (c)
              
              
              --Additional
      contributed capital
              
              
              56
              
              
              
              1,036
              
              (c)
              
              
              (56
              )
              (c)
              
              
              1,036Predecessor
      stock held in treasury, at cost
              
              
              (251
              )
              
              
              --
              
              
              
              
              251
              
              (c)
              
              
              --Predecessor
      net deficiency of assets at spin-off
              
              
              (113
              )
              
              
              --
              
              
              
              
              113
              
              (c)
              
              
              --Accumulated
      other comprehensive income (loss)
              
              
              (97
              )
              
              
              127
              
              (a)
              
              
              (30
              )
              (c)
              
              
              --Accumulated
      deficit
              
              
              (1,284
              )
              
              
              (100
              )
              (c)
              
              
              1,384
              
              (c)
              
              
              --Total
      Shareholders’ Equity (Deficit)
              
              
              (1,688
              )
              
              
              1,064
              
              
              
              
              1,661
              
              
              
              
              1,037Total
      Liabilities and Shareholders’ Equity (Deficit)
              
              $
              2,794
              
              
              $
              44
              
              
              
              $
              1,916
              
              
              
              $
              4,754
   7
  SOLUTIA
INC.
  NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars in
millions, except per share amounts or otherwise noted )
 (Unaudited)
 (a)
              To
      record the discharge and payment of liabilities subject to
      compromise,
      payment of accrued post-petition interest, the re-establishment of
      liabilities to be retained by Successor, the defeasance of a substantial
      amount of our postretirement liabilities and the establishment of SFC LLC,
      a fund restricted to the payment of certain Legacy
      Liabilities.(b)
              To
      record the extinguishment of Predecessor debt and the write-off of any
      related unamortized debt financing costs and the establishment of
      Successor debt financing and related financing costs pursuant to our
      Financing Agreements.(c)
              To
      record the net effect of discharge of claims and liabilities subject to
      compromise, gain on the revaluation of assets and liabilities,
      cancellation of Predecessor common stock, close out of remaining equity
      balances of Predecessor in accordance with fresh-start accounting, and the
      issuance of Successor common stock and warrants to purchase common
      stock.(d)
              To
      adjust assets and liabilities to fair value.(e)
              The
      goodwill of Predecessor has been eliminated and the reorganization value
      in excess of amounts allocable to identified tangible and intangible
      assets has been classified as
goodwill.
 
 Liabilities
Subject to Compromise
 
 Liabilities
subject to compromise refers to pre-petition obligations that were impacted by
the Chapter 11 Cases.  The amounts represented our estimate of known
or potential obligations to be resolved in connection with our Chapter 11
Cases.  The following table summarizes the components of liabilities
subject to compromise included in our Consolidated Statement of Financial
Position as of December 31, 2007:
 
 PredecessorDecember
      31,
                2007Postretirement
      benefits
              
              $
              664Litigation
      reserves
              
              
              106Accounts
      payable
              
              
              102Environmental
      reserves
              
              
              80Other
      miscellaneous liabilities
              
              
              3116.72%
      debentures due 2037
              
              
              1507.375%
      debentures due 2027
              
              
              30011.25%
      notes due 2009
              
              
              223673Unamortized
      debt discount and debt issuance costs
              
              
              (14
              )Total
      Debt Subject to Compromise
              
              
              659Total
      Liabilities Subject to Compromise
              
              $
              1,922
 
  
 8
 SOLUTIA
INC.
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
  Reorganization
Items, net
 
 Reorganization
items, net are presented separately in the Consolidated Statement of Operations
and represent items of income, expense, gain or loss that we realized or
incurred due to our reorganization under Chapter 11 of the U.S. Bankruptcy
Code.
 
 Reorganization
items, net consisted of the following items:
 
 PredecessorTwo
      Months
                    Ended
                    February
      29,
                    2008
                  
                  
                  Three
      Months
                    Ended
                    June
      30,
                    2007
                  
                  
                  Six
      Months
                    Ended
                    June
      30,
                    2007Discharge
      of claims and liabilities (a)
                  
                  $
                  (104
                  )
                  
                  $
                  --
                  
                  
                  $
                  --Revaluation
      of assets and liabilities (b)
                  
                  
                  1,798
                  
                  
                  
                  --
                  
                  
                  
                  --Professional
      fees (c)
                  
                  
                  (52
                  )
                  
                  
                  (17
                  )
                  
                  
                  (32
                  )Severance
      and employee retention costs (d)
                  
                  
                  --
                  
                  
                  
                  (2
                  )
                  
                  
                  (3
                  )Settlements
      of pre-petition claims (e)
                  
                  
                  --
                  
                  
                  
                  2
                  
                  
                  
                  2Total
      Reorganization Items, net
                  
                  $
                  1,642
                  
                  
                  $
                  (17
                  )
                  
                  $
                  (33
                  )
  (a)
              The
      discharge of claims and liabilities primarily relates to allowed general,
      unsecured claims in our Chapter 11 proceedings, such as (1) claims due to
      the rejection or modification of certain executory contracts, (2) claims
      relating to changes in postretirement healthcare benefits and the
      rejection of our non-qualified retirement plans, and (3) claims relating
      to the restructuring of financing arrangements.(b)
              We
      revalued our assets and liabilities at estimated fair value as a result of
      fresh-start accounting.  This resulted in a $1,798 pre-tax gain,
      primarily reflecting the fair value of newly recognized intangible assets,
      the elimination of our LIFO reserve and the increase in the fair value of
      tangible property and equipment.(c)
              Professional
      fees for services provided by debtor and creditor professionals directly
      related to our reorganization proceedings.(d)
              Expense
      provisions related to (i) employee severance costs incurred directly as
      part of the Chapter 11 reorganization process and (ii) a retention plan
      for certain of our employees approved by the Bankruptcy
    Court.(e)
              Represents
      the difference between the settlement amount of certain pre-petition
      obligations and the corresponding amounts previously
    recorded.
 
 We did
not incur any additional reorganization items, net in the three or four months
ended June 30, 2008.
 
 3.  Significant
Accounting Policies
 
 Basis
of Presentation
 
 These
financial statements should be read in conjunction with the audited consolidated
financial statements and notes to consolidated financial statements included in
our 2007 Annual Report on Form 10-K (“2007 Form 10-K”), as re-casted and filed
with the Securities and Exchange Commission (“SEC”) in a Form 8-K on July 25,
2008, to reflect our segment reporting change as described in Note
13.
 
 The
consolidated financial statements for the period in which we were in bankruptcy
were prepared in accordance with SOP 90-7 and on a going concern basis, which
assumes the continuity of operations and reflects the realization of assets and
satisfaction of liabilities in the ordinary course of business.
 
 In
accordance with SOP 90-7, we adopted fresh-start accounting as of the Effective
Date.  However, due to the proximity of the Effective Date to the
February month end, for accounting convenience purposes, we have reported the
effects of fresh-start accounting as if they occurred on February 29,
2008.  Furthermore, as a result of the adoption of fresh-start
accounting and as noted below, certain of our significant accounting policies
have been updated.  See Note 2 for further details on the adoption of
fresh-start accounting.
 
 Reclassifications
 
 Upon
emergence, we changed the classification of certain items in our Consolidated
Statement of Operations.  We also reclassified prior period amounts to
conform to current period presentation.  These changes have no impact
on operating income or net income (loss) in any period prior to or subsequent to
our emergence.  These reclassifications are as follows for the three
and six months ended June 30, 2007:
 
 Marketing
expenses:We reclassified $36 and $67 of expenses for the
three and six months ended June 30, 2007, respectively, previously presented
separately as marketing expenses on the Consolidated Statement of Operations to
selling, general and administrative expenses.
 
 Administrative
expenses:  We reclassified $22 and $47 of expenses for the
three and six months ended June 30, 2007, respectively, previously presented as
administrative expenses on the Consolidated Statement of Operations as
follows:
  Three
      Months
                Ended
                June
      30,
                2007
              
              
              Six
      Months
                Ended
                June
      30,
                2007Selling,
      general and administrative expenses
              
              $
              29
              
              
              $
              54Research,
      development and other operating expenses, net
              
              
              (7
              )
              
              
              (7
              )
 9
 SOLUTIA
INC.
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
  Technological
expenses:  We reclassified $11 and $21 of expenses for the
three and six months ended June 30, 2007, respectively, previously presented as
technological expenses on the Consolidated Statement of Operations as
follows:
 
 Three
      Months
                Ended
                June
      30,
                2007
              
              
              Six
      Months
                Ended
                June
      30,
                2007Selling,
      general and administrative expenses
              
              $
              1
              
              
              $
              3Research,
      development and other operating expenses, net
              
              
              10
              
              
              
              18
 
 Amortization
expense:We reclassified $1 of expense for both the three and
six months ended June 30, 2007, respectively, previously presented as
amortization expense on the Consolidated Statement of Operations to selling,
general and administrative expenses.
 
 Use
of Estimates
 
 The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets
and  liabilities and disclosure of contingent assets and liabilities
at the date of the financial statements which affect revenues and expenses
during the period reported.  Estimates are adjusted when necessary to
reflect actual experience.  Significant estimates were used to account
for fresh-start accounting, restructuring reserves, environmental reserves,
employee benefit plans, intangible assets, income taxes, asset impairments and
contingencies.  Actual results could materially differ from those
estimates.
 
 Inventory
Valuation
 
 Inventories
are stated at cost or market, whichever is less.  Actual cost is used
to value raw materials and supplies. Standard cost, when it approximates actual
cost, is used to value finished goods and goods in
process.  Variances, exclusive of unusual volume and operating
performance, are capitalized into inventory when material. Standard cost
includes direct labor and raw materials, and manufacturing overhead based on
practical capacity.  Prior to March 1, 2008, the cost of inventories
in the United States, excluding supplies and the inventories of the CPFilms and
rubber chemicals operations (66 percent as of December 31, 2007) was determined
by the last-in, first-out ("LIFO") method, which generally reflects the effects
of inflation or deflation on cost of goods sold sooner than other inventory cost
methods and all remaining inventories were determined by the first-in, first-out
("FIFO") method.  As of March 1, 2008, the cost of all inventories in
the United States, excluding supplies (63 percent as of June 30, 2008) is
determined by the LIFO method.  The cost of inventories outside the
United States, as well as supplies inventories in the United States, is
determined by the FIFO method.
  Property,
Plant and Equipment
 
 Property,
plant and equipment are recorded at cost and depreciated on a straight-line
method over their respective estimated useful lives.  In connection
with our adoption of fresh-start accounting, we adjusted the net book values of
property and equipment to their estimated fair values and revised the estimated
useful life of machinery and equipment. The estimated useful lives for major
asset classifications are as follows:
 
 
 Estimated Useful LivesAsset Classification
              Successor
              PredecessorBuildings
      and Improvements
              5
      to 35 years
              5
      to 35 yearsMachinery
      and Equipment
              5
      to 20 years
              3
      to 15 years
 
 Periodically,
we conduct a complete shutdown of certain manufacturing units (“turnaround”) to
perform necessary inspections, repairs and maintenance.  Costs
associated with significant turnarounds, which include estimated costs for
material, labor, supplies and contractor assistance, are deferred and amortized
ratably during the period between each planned activity, which generally occurs
every 2 to 3 years.
 
 Goodwill
and Intangible Assets
 
 Goodwill
reflects the excess of the reorganization value of the Successor over the fair
value of tangible and identifiable intangible assets from our adoption of
fresh-start accounting.  Intangible assets that have finite useful
lives are amortized over their determinable useful lives.  The
estimated useful lives are as follows:
 
 Estimated Useful LivesSuccessor
              PredecessorFinite-Lived
      Intangible Assets
              5
      to 27 years
              5
      to 25 years
 
 10
 SOLUTIA
INC.
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
  Goodwill and
indefinite-lived intangible assets are assessed annually for impairment in the
fourth quarter, or more frequently if circumstances arise which indicate they
may not be recoverable.
 
 Derivative
Financial Instruments
 
 In
accordance with SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities(“SFAS No. 133”), as amended, all
derivatives, whether designated for hedging relationships or not, are recognized
in the Consolidated Statement of Financial Position at their fair
value.
 
 Currency
forward and option contracts are used to manage currency exposures for financial
instruments denominated in currencies other than the entity’s functional
currency.We have
chosen not to designate these instruments as hedges and to allow the gains and
losses that arise from marking the contracts to market to be included in Other
Income, net in the Consolidated Statement of Operations.
 
 Interest
rate caps and swaps are used to manage interest rate exposures on variable rate
debt instruments.  These market instruments are designated as cash
flow hedges.  The mark-to-market gain or loss on qualifying hedges is
included in Accumulated Other Comprehensive Income in the Consolidated Statement
of Financial Position to the extent effective, and reclassified into Interest
Expense in the Consolidated Statement of Operations in the period during which
the hedged transaction affects earnings.  The mark-to-market gains or
losses on ineffective portions of hedges are recognized in Interest Expense
immediately.
 
 Natural
gas forward and option contracts are used to manage some of the exposure for the
cost of natural gas.  These market instruments are designated as cash
flow hedges.  The mark-to-market gain or loss on qualifying hedges is
included in Accumulated Other Comprehensive Income in the Consolidated Statement
of Financial Position to the extent effective, and reclassified into Cost of
Goods Sold in the Consolidated Statement of Operations in the period during
which the hedged transaction affects earnings.  The mark-to-market
gains or losses on ineffective portions of hedges are recognized in Cost of
Goods Sold immediately.
 
 Recently
Issued Accounting Standards
 
 In March
2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities, (“SFAS No. 161”).  SFAS No.
161 amends and expands the disclosure requirements of SFAS No. 133 and requires
entities to provide enhanced qualitative disclosures about objectives and
strategies for using derivatives, quantitative disclosures about fair values and
amounts of gains and losses on derivative contracts, and disclosures about
credit-risk-related contingent features in derivative agreements.  The
provisions of SFAS No. 161 are effective for fiscal years beginning after
November 15, 2008.  We are currently evaluating the impact of SFAS No.
161 on the consolidated financial statements.
 
 11
 SOLUTIA
INC.
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
 4.  Divestiture
 
 Discontinued
Operations – Water Treatment Phosphonates Business
 
 On
May 31, 2007, we sold DEQUEST®, our water treatment phosphonates business
(“Dequest”) to Thermphos Trading GmbH (“Thermphos”).  Under the terms
of the agreement, Thermphos purchased the assets and assumed certain of the
liabilities of Dequest for $67, subject to a working capital
adjustment.  As part of the closing of the sale, our affiliated
companies and Thermphos entered into a ten year lease and operating agreement
under which we will continue to operate the Dequest production facility for
Thermphos at our plant in Newport, Wales, United Kingdom.  We do not
consider the cash flows generated by the lease and operating agreement to be
direct cash flows of Dequest since we have not retained any risk or reward in
the business.
 
 Dequest was a component of the
Performance Products segment (prior to segment realignment further described in
Note 13) prior to the classification as discontinued operations.  We
recorded a gain on the sale of Dequest of $34.
 
 Net sales
and income from discontinued operations for the three and six months ended June
30, 2007 are as follows:
 
 Three
      Months
                Ended
                June
      30,
                2007
              
              
              Six
      Months
                Ended
                June
      30,
                2007Net
      sales
              
              $
              18
              
              
              $
              43Income
      before income taxes
              
              $
              34
              
              
              $
              34Income
      tax expense
              
              
              5
              
              
              
              5Income
      from discontinued operations
              
              $
              29
              
              
              $
              29
 
 5.  Share-Based
Compensation
 
 Predecessor
 
 In
accordance with the Plan, all existing equity interests, including shares
authorized for grant and options outstanding under the Solutia Inc. 2000
Stock-Based Incentive Plan and the Solutia Inc. 1997 Stock-Based Incentive Plan,
and the underlying plans, were cancelled upon the Effective Date.
 
 Successor
 
 On the
Effective Date, we adopted the Solutia Inc. 2007 Management Long-Term Incentive
Plan (“2007 Management Plan”).  The 2007 Management Plan authorizes up
to 7,200,000 shares of our common stock for grants of non-qualified and
incentive stock options, stock appreciation rights, restricted stock, restricted
stock units and other stock awards.  The shares used may be newly
issued shares, treasury shares or a combination.  As of June 30, 2008,
2,793,969 shares from the 2007 Management Plan remained available for
grants.
 
 Also on
the Effective Date, we adopted the Solutia Inc. 2007 Non-Employee Director Stock
Compensation Plan (“2007 Director Plan”).  The 2007 Director Plan
authorizes up to 250,000 shares of our common stock for grants of stock options,
stock appreciation rights, restricted stock, restricted stock units and other
stock awards.  The shares used may be newly issued shares, treasury
shares or a combination.  As of June 30, 2008, 203,840
shares from the 2007 Director Plan remained available for
grants.
 
 Stock
Options
 
 We
granted options to purchase a total of 2,924,167 shares of common stock to
eligible employees under the 2007 Management Plan during the four months ended
June 30, 2008.  The options (i) have an exercise price of not less
than 100 percent of the fair market value of the common stock on the grant date,
(ii) become exercisable in three equal installments on the first, second, and
third anniversary of the grant date, subject to the employee’s continued
employment and (iii) expire on the tenth anniversary of the grant
date.
 
 12
 SOLUTIA
INC.
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
  The fair value of stock
options is determined at the grant date using a Black-Scholes model, which
requires us to make several assumptions.  The risk-free rate is based
on the U.S. Treasury yield curve in effect for the expected term of the options
at the time of grant.  The dividend yield on our common stock is
assumed to be zero since we do not pay dividends and have no current plans to do
so.  Due to our Chapter 11 Cases, our historical volatility data and
employee stock option exercise patterns were not considered in determining the
volatility data and expected life assumptions.  The volatility
assumptions were based on (i) historical volatilities of the stock of comparable
chemical companies whose shares are traded using daily stock price returns
equivalent to the expected term of the options and (ii) implied
volatility.  The expected life of an option was determined based on a
simplified assumption that the option will be exercised evenly from the time it
becomes exercisable to expiration, as allowed by SEC Staff Accounting Bulletin
No. 110.
 
 The
weighted-average fair value of options granted during the four months ended June
30, 2008 was determined based on the following weighted-average
assumptions:
 
 SuccessorJune
      30,
                2008Expected
      volatility
              
              
              26.1
              %Expected
      term (in years)
              
              
              6Risk-free
      rate
              
              
              4.24
              %Weighted-average
      grant date fair value
              
              $
              5.92
 
 A summary
of stock option activity for the four months ended June 30, 2008 is as
follows:
 
 Options
              
              
              Weighted-Average
                Exercise Price
              
              
              Weighted-Average
                Remaining
                Contractual Life
              
              
              Aggregate
                Intrinsic
                Value (a)Outstanding
      at March 1, 2008
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              --Granted
              
              
              2,911,000
              
              
              $
              17.33
              
              
              
              --
              
              
              
              --Exercised
              
              
              --
              
              
              
              0.00
              
              
              
              --
              
              
              
              --Forfeited
              
              
              --
              
              
              
              0.00
              
              
              
              --
              
              
              
              --Outstanding
      at March 31, 2008
              
              
              2,911,000
              
              
              $
              17.33
              
              
              
              9.9
              
              
              $
              (10
              )Granted
              
              
              13,167
              
              
              
              12.87
              
              
              
              --
              
              
              
              --Exercised
              
              
              --
              
              
              
              0.00
              
              
              
              --
              
              
              
              --Forfeited
              
              
              18,000
              
              
              
              17.33
              
              
              
              --
              
              
              
              --Outstanding
      at June 30, 2008
              
              
              2,906,167
              
              
              $
              17.31
              
              
              
              9.7
              
              
              $
              (13
              )Exercisable
      at June 30, 2008
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              --
 
 (a)
              Intrinsic
      value for stock options is calculated based on the difference between the
      exercise price of the underlying awards and the quoted market price of our
      common stock as of the reporting
date.
 
 13
 SOLUTIA
INC.
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)


During
both the three and four months ended June 30, 2008, we recognized $1 of
compensation expense related to our stock options.  Pre-tax
unrecognized compensation expense for stock options, net of estimated
forfeitures, was $15 as of June 30, 2008 and will be recognized as expense over
a remaining weighted-average period of 5.7 years.
 
 Restricted Stock
Awards
 
 We
granted 1,499,864 shares and 46,160 shares of restricted stock awards to
eligible employees under the 2007 Management Plan and to our non-employee
directors under the 2007 Director Plan, respectively, during the four months
ended June 30, 2008.
 
 A summary
of restricted stock award activity for the four months ended June 30, 2008 is as
follows:
 
 Shares
              
              
              Weighted-Average

                Grant Date Fair ValueOutstanding
      at March 1, 2008
              
              
              --
              
              
              
              --Granted
              
              
              1,181,960
              
              
              $
              17.10Vested
              
              
              --
              
              
              
              0.00Forfeited
              
              
              --
              
              
              
              0.00Outstanding
      at March 31, 2008
              
              
              1,181,960
              
              
              $
              17.10Granted
              
              
              364,064
              
              
              
              13.29Vested
              
              
              --
              
              
              
              0.00Forfeited
              
              
              --
              
              
              
              0.00Outstanding
      at June 30, 2008
              
              
              1,546,024
              
              
              $
              16.20
 
 During
both the three and four months ended June 30, 2008, we recognized $3 of
compensation expense related to our restricted stock awards.  Pre-tax
unrecognized compensation expense for restricted stock awards, net of estimated
forfeitures, was $21 as of June 30, 2008 and will be recognized as expense over
a remaining weighted-average period of 2.3 years.
  6.  Goodwill
and Other Intangible Assets
 
 Goodwill
 
 As a
result of applying fresh-start accounting, the Successor recorded goodwill of
$524 as of June 30, 2008 and the allocation by reportable segment is as
follows:
 
 SuccessorJune
      30,
                2008SAFLEX®
              
              $
              206CPFilms
              
              
              159Technical
      Specialties
              
              
              159Integrated
      Nylon
              
              
              --Total
              
              $
              524
 
 14
 SOLUTIA
INC.
  NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
 Identified Intangible
Assets
 
 Identified intangible assets generally
are comprised of (i) amortizable customer relationships, unpatented technology,
contract-based intangible assets, trade names and patents and (ii)
indefinite-lived trademarks not subject to amortization.  The value
assigned to the identified intangible assets upon the adoption of fresh-start
accounting represents our best estimates of fair value based on internal and
external valuations.  These intangible assets are summarized in
aggregate as follows:
 
 Successor
                June 30, 2008
              
              
              Predecessor
                December 31, 2007Estimated
                Useful
                Life
      in
                Years
              
              
              Gross
                Carrying
                Value
              
              
              Accumulated
                Amortization
              
              
              Net
                Carrying
                Value
              
              
              Estimated
                Useful
                Life
      in
                Years
              
              
              Gross
                Carrying
                Value
              
              
              Accumulated
                Amortization
              
              
              Net
                Carrying
                ValueAmortizable
      intangible assets:Customer
      relationships
              
              23
      to 27
              
              
              $
              503
              
              
              $
              (6
              )
              
              $
              497
              
              
              
              12
              
              
              $
              1
              
              
              $
              (--
              )
              
              $
              1Technology
              
              5
      to 26
              
              
              
              211
              
              
              
              (4
              )
              
              
              207
              
              
              15
      to 25
              
              
              
              18
              
              
              
              (1
              )
              
              
              17Trade
      names
              
              
              25
              
              
              
              14
              
              
              
              (--
              )
              
              
              14
              
              
              16
      to 25
              
              
              
              2
              
              
              
              (--
              )
              
              
              2Patents
              
              
              13
              
              
              
              5
              
              
              
              (--
              )
              
              
              5
              
              
              5
      to 10
              
              
              
              2
              
              
              
              (--
              )
              
              
              2Contract-based
              
              
              
              
              
              
              --
              
              
              
              (--
              )
              
              
              --
              
              
              5
      to 20
              
              
              
              18
              
              
              
              (8
              )
              
              
              10Non
      amortizable intangible
                assets:Trademarks
              
              
              
              
              
              
              157
              
              
              
              --
              
              
              
              157
              
              
              
              
              
              
              
              26
              
              
              
              --
              
              
              
              26Total
      Identified Intangible Assets
              
              
              
              
              
              $
              890
              
              
              $
              (10
              )
              
              $
              880
              
              
              
              
              
              
              $
              67
              
              
              $
              (9
              )
              
              $
              58
  During
the three and four months ended June 30, 2008, we recognized $7 and $10,
respectively, of amortization expense.  Amortization expense is
allocated to cost of goods sold and selling, general and administrative expenses
in the Consolidated Statement of Operations as follows:
  Three
      Months
                Ended
                June
      30,
                2008
              
              
              Four
      Months
                Ended
                June
      30,
                2008Cost
      of goods sold
              
              $
              2
              
              
              $
              3Selling,
      general and administrative expenses
              
              
              5
              
              
              
              7
 
 We
expect amortization expense for intangible assets to be approximately $25 in
2008 and $30 from 2009 through 2012.
 
 7.  Detail
of Certain Balance Sheet Accounts
 
 Successor
              
              
              PredecessorInventories
              
              June
      30,
                2008
              
              
              December
      31,
                2007Finished
      goods
              
              $
              436
              
              
              $
              348Goods
      in process
              
              
              225
              
              
              
              182Raw
      materials and supplies
              
              
              137
              
              
              
              126Inventories,
      at FIFO cost
              
              
              798
              
              
              
              656Excess
      of FIFO over LIFO cost
              
              
              --
              
              
              
              (239
              )Total
      Inventories
              
              $
              798
              
              
              $
              417
 
 In
connection with the adoption of fresh-start accounting, inventories were
recorded at fair value resulting in the elimination of the LIFO reserve and a
step-up in basis of $74 at the Effective Date.  Of the $74 step-up in
basis, $49 and $74 was charged to Cost of Goods Sold in the Successor
Consolidated Statement of Operations for the three and four months ended June
30, 2008, respectively.
 
 15
 SOLUTIA
INC.
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
   Successor
              
              
              PredecessorProperty,
      Plant and Equipment
              
              June
      30,
                2008
              
              
              December
      31,
                2007Land
              
              $
              83
              
              
              $
              37Leasehold
      improvements
              
              
              9
              
              
              
              41Buildings
              
              
              235
              
              
              
              504Machinery
      and equipment
              
              
              1,084
              
              
              
              3,105Construction
      in progress
              
              
              95
              
              
              
              64Total
      property, plant and equipment
              
              
              1,506
              
              
              
              3,751Less
      accumulated depreciation
              
              
              (34
              )
              
              
              (2,699
              )Total
              
              $
              1,472
              
              
              $
              1,052
 
 Successor
              
              
              PredecessorAccrued
      Liabilities
              
              June
      30,
                2008
              
              
              December
      31,
                2007Wages
      and benefits
              
              $
              56
              
              
              $
              96Environmental
      remediation liabilities
              
              
              42
              
              
              
              17Accrued
      selling expenses
              
              
              25
              
              
              
              27Accrued
      taxes payable
              
              
              24
              
              
              
              16Accrued
      interest
              
              
              9
              
              
              
              24Other
              
              
              146
              
              
              
              116Total
      Accrued Liabilities
              
              $
              302
              
              
              $
              296
 
 
 16
 SOLUTIA
INC.
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
 8.  Income
Taxes
 
 Income
Tax Expense
 
 No income
tax expense or benefit was recorded for the three and four months ended June 30,
2008. We recorded income tax expense in the three and six months ended June 30,
2007 of $7 and $14, respectively.
 
 Our
income tax expense or benefit is affected by the mix of income and losses in the
tax jurisdictions in which we operate.  For the three and four months
ended June 30, 2008, our effective tax rate of zero differs from the U.S.
statutory rate because in jurisdictions in which we experience losses,
predominately the U.S., we have recorded a valuation allowance against the tax
benefit.  For the three months ended June 30, 2007, our effective tax
rate was lower than the U.S. statutory rate due to our mix of earnings between
ex-U.S. tax jurisdictions, where statutory rates are lower, and the U.S., where
no tax expense is provided due to the release of valuation allowances, partially
offset by an increase in unrecognized tax benefits.  For the six
months ended June 30, 2007, our effective tax rate was higher than the U.S.
statutory rate, due to the increase in unrecognized tax benefits partially
offset by earnings in ex-U.S. tax jurisdictions, where statutory rates are
lower.
 
 We
recorded income tax expense for the two months ended February 29, 2008 of
$215.  In conjunction with our emergence from bankruptcy and the
adoption of fresh-start accounting, we recorded deferred tax expense on the
revaluation of our inventory, fixed assets and identified intangible assets and
income tax expense on increases in our unrecognized tax benefit
liabilities.  We also recorded income tax expense on earnings of
ex-U.S. operations for the two months ended February 29, 2008.  Our
effective tax rate was lower than the U.S. statutory rate, predominantly due to
our mix of earnings, including U.S. reorganization items, in tax jurisdictions
where no tax expense is provided due to the release of valuation
allowances.
 
 Unrecognized
Tax Benefits
 
 The total
amount of unrecognized tax benefits at June 30, 2008 and December 31, 2007 was
$175 and $146, respectively.  The increase in this
amount is mainly the result of currency exchange rate fluctuations and tax
positions related to events in the current year.  Included in
the balance at June 30, 2008 and December 31, 2007 were $64 and $50,
respectively, of unrecognized tax benefits that, if recognized, would affect the
effective tax.
 
 We file
income tax returns in the United States and various states and foreign
jurisdictions.  With few exceptions, we are no longer subject to U.S.
federal, state and local, or non-U.S. income tax examinations by tax authorities
for years before 2002.   It is reasonably possible that within
the next 12 months as a result of the resolution of Federal, state and foreign
examinations and appeals, and the expiration of various statutes of limitation
that the unrecognized tax benefits that would affect the effective tax rate will
decrease by a range of $0 to $18 and the unrecognized tax benefits that would
not affect the effective tax rate will decrease by a range of $0 to
$8.
  Net
Operating Loss and Valuation Allowance
 
 Upon
emergence from bankruptcy, Successor has an estimated U.S. tax net operating
loss carryforward (“NOL”) of approximately $1.2 billion as of March 1,
2008.  As a result of the issuance of new common stock upon emergence,
we realized a change of ownership for purposes of Section 382 of the Internal
Revenue Code.  We do not currently expect this change to significantly
limit our ability to utilize our NOL in the carryforward period.
 9.  Restructuring
Costs
 
 On May 21, 2008, we announced the
planned exit of our manufacturing facility in Ruabon, Wales, United Kingdom (the
“Ruabon Facility”) within the Technical Specialties segment.  We
expect to cease our manufacturing at the Ruabon Facility by the end of 2008 with
a final closure by the end of 2011.  The decision to cease
manufacturing of the three product lines at the Ruabon Facility is due to the
over-supplied market from higher competition from principally Far Eastern
producers, resulting in the Ruabon Facility no longer being cost competitive on
a global scale.  We expect to incur charges ranging from $45 to $60
over the next four years.  Estimates of the total cost we expect to incur
for each major type of cost are:  (i) $17 to $22 for severance and
retraining costs, (ii) $13 to $16 for indirect residual costs which we are
contractually obligated to incur to continue providing third party operations at
the site for the next two years, and (iii) $15 to $22 for other costs including
clean-out and demolition costs.  During the three months ended June 30,
2008, $1 of severance and retraining costs were recorded for the exit of the
Ruabon Facility in Cost of Goods Sold.
 
 17
 SOLUTIA
INC.
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
 A summary
of restructuring activity during the two months ended February 29, 2008 and the
three and four months ended June 30, 2008 is as follows:
 
 Future
                Contractual
                Payments
              
              
              Employment
                Reductions
              
              
              TotalPredecessorBalance
      at December 31, 2007
              
              $
              3
              
              
              $
              5
              
              
              $
              8Amounts utilized
              
              
              --
              
              
              
              (1
              )
              
              
              (1
              )Currency
      fluctuations
              
              
              --
              
              
              
              1
              
              
              
              1Balance
      at February 29, 2008
              
              
              3
              
              
              
              5
              
              
              
              8SuccessorAmounts utilized
              
              
              --
              
              
              
              --
              
              
              
              --Balance
      at March 31, 2008
              
              
              3
              
              
              
              5
              
              
              
              8Charges taken
              
              
              --
              
              
              
              1
              
              
              
              1Amounts utilized
              
              
              --
              
              
              
              (2
              )
              
              
              (2
              )Balance
      at June 30, 2008
              
              $
              3
              
              
              $
              4
              
              
              $
              7
 
 10.  Commitments
and Contingencies
 
 Litigation
 
 Because
of the size and nature of our business, we are a party to numerous legal
proceedings.  Most of these proceedings have arisen in the ordinary
course of business and involve claims for money damages.
 
 Legal Proceedings Resolved
in Our Chapter 11 Process
 
 Certain
adversary proceedings and claim objections, as summarized in our 2007 Form 10-K
as Citigroup Global Markets,
et al. Adversary Proceeding,JPMorgan Adversary
Proceeding,Equity
Committee Adversary Proceeding Against Monsanto and Pharmacia,andDispute
Regarding Proof of Claim of Bank of New York, were resolved as
part of our emergence from Chapter 11 through the distributions made under the
Plan, or with the establishment of a disputed claim reserve from which future
New Common Stock distributions will be made. Further, with respect to the matter
captioned as Savings and
Investment Plan Litigationin the 2007 Form 10-K,in December 2007, the
parties to the Savings and Investment Plan bankruptcy claim and litigation
reached a global settlement of all outstanding issues and subsequently entered
into a formal settlement agreement to that effect.  The amount of the
settlement to be paid in New Common Stock is less than the $15 disputed claims
reserve established for such matter.  The United States District
Court, Southern District of New York has tentatively approved the settlement and
has scheduled a fairness hearing for September 17, 2008 for final confirmation.
In connection with the settlement, the Department of Labor has provided notice
it will take no further action arising out of its investigation of the Savings
and Investment Plan (captioned in the 2007 Form 10-K as Department of Labor Investigation of
Solutia Inc. Savings and Investment Plan), pending final confirmation of
the settlement.
 
 18
 SOLUTIA
INC.
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)






Legal
Proceedings Ongoing Post-Chapter 11





Following
is a summary of legal proceedings that, if resolved unfavorably, could have a
material adverse effect on our consolidated liquidity and
profitability.  Certain of these matters relate to Flexsys, which
became a 100% owned subsidiary on May 1, 2007 upon our acquisition of the 50%
interest owned by Akzo Nobel.  All claims in the antitrust and tort
litigation matters described below regard alleged conduct occurring while
Flexsys was a joint venture of Solutia and Akzo Nobel, and any potential damages
in these cases would be evenly apportioned between Solutia and Akzo
Nobel.





Flexsys
Antitrust Litigation





Antitrust
authorities in the United States, Europe and Canada have been investigating past
commercial practices in the rubber chemicals industry including the practices of
Flexsys.  The practices being investigated occurred during the period
that Flexsys was a 50/50 joint venture between Solutia and Akzo
Nobel.  The European Commission issued the findings from its
investigation in 2005, in which the Commission granted Flexsys full immunity
from any potential fines.  Investigations regarding the industry may
still be on-going in the United States and Canada, but to date, no findings have
been made against Flexsys in either country.





In
addition, a number of purported civil class actions have been filed against
Flexsys and other producers of rubber chemicals on behalf of indirect
purchasers of rubber chemical products.  A series of such
purported class actions have been filed against Flexsys in various state courts
in the United States and in four courts in Canada. However, all
of these cases have been dismissed, or are currently subject to confirmed or
tentative settlements.





Flexsys
Patent and Related Litigation





Flexsys
holds various patents covering inventions in the manufacture of rubber
chemicals, including patents describing and claiming a manufacturing process for
4-aminodiphenylamine ("4-ADPA"), a key building block for the manufacture of
6PPD and IPPD, as well as a manufacturing process for 6PPD and IPPD, which
function as anti-degradants and are used primarily in the manufacture of rubber
tires.  Flexsys is engaged in litigation in several jurisdictions to
protect and enforce its patents.





Legal
Proceedings in the United States





The ITC-1
proceeding.  In February 2005, Flexsys filed a complaint with
the U.S. International Trade Commission ("ITC"), requesting that the ITC
initiate an investigation against Sinorgchem Co. Shangdong, a Chinese entity
("Sinorgchem"), Korea Kumho Petrochemical Company, a Korean company ("KKPC"),
and third party distributors of Sinorgchem.  Flexsys claims that the
process Sinorgchem uses to make 4-ADPA and 6PPD, its sale of 6PPD for
importation into the United States, and Sinorgchem's sale of 4-ADPA to KKPC and
KKPC's importation of 6PPD into the United States are covered by Flexsys’
patents.  Accordingly, Flexsys requested that the ITC issue a limited
exclusion order prohibiting the importation into the United States of 4-ADPA and
6PPD originating from these entities.  In February 2006, an
Administrative Law Judge ("ALJ") of the ITC determined that Flexsys’ patents
were valid, that the process used by Sinorgchem to make 4-ADPA and 6PPD was
covered by Flexsys’ patents, and that Sinorgchem and its distributor, but not
KKPC, had violated section 1337 of the U.S. Tariff Act.  In July 2006,
the ITC substantially upheld the ALJ's decision on the basis of literal
infringement, and subsequently issued a limited exclusion order against
Sinorgchem and its distributor prohibiting them from importing 4-ADPA and 6PPD
manufactured by Sinorgchem into the United States.





Sinorgchem
appealed the ITC decision to the United States Court of Appeals for the Federal
Circuit. On December 21, 2007, a three-judge panel of the Federal Circuit
overruled the ITC’s finding that Sinorgchem had literally infringed Flexsys’
patent and remanded the matter to the ITC to determine whether Sinorgchem’s
processes infringe Flexsys’ patent on other grounds set forth by
Flexsys.  The limited exclusion order was lifted, and the matter is
currently before the ALJ for consideration of the infringement claim on these
other grounds.





19


SOLUTIA
INC.
  NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
  The
ITC-2 proceeding.  In May 2008, Flexsys filed a second
complaint with the ITC, requesting that the ITC initiate an investigation
against Sinorgchem, KKPC, Kumho Tire Co. Inc., and Kumho Tire USA,
Inc.  Flexsys’ complaint requests that the ITC issue a limited
exclusion order prohibiting the importation into the United States of 4-ADPA and
6PPD originating from these entities. The May 2008 ITC complaint alleges that
Sinorgchem violated Flexsys’ patents for producing intermediate materials used
to make 4-ADPA.  The ITC formally instituted an investigation pursuant
to this complaint on July 3, 2008.





United States Civil Patent
Infringement Litigation.  In January 2005, Flexsys filed suit
in United States District Court for the Northern District of Ohio for patent
infringement against Sinorgchem, KKPC, Kumho Tire Korea and Kumho Tire USA,
affiliates of KKPC, and certain other tire distributors seeking monetary damages
as well as injunctive relief.  This action is currently stayed pending
resolution of the ITC-1
matter described above.





In re Rubber Chemicals Antitrust
Litigation.  In April 2006, KKPC filed suit against Flexsys in
the United States District Court for the Central District of California for
alleged violations of the Sherman Act, breach of contract, breach of the implied
covenant of good faith and fair dealing, declaratory relief, intentional
interference with prospective economic advantage, disparagement and violations
of the California Business & Professions Code.  This matter was
subsequently transferred to the United States District Court, Northern District
of California.  The court dismissed KKPC’s initial complaint, but
granted KKPC the right to refile an amended complaint, which KKPC filed in
September 2007.  Flexsys filed a motion to dismiss the amended
complaint, which was granted in part, and denied in
part.  Specifically, the court dismissed all pending antitrust claims
against Flexsys, but did not dismiss two state law claims for unfair competition
and tortious interference.  The court granted KKPC the right to refile
another amended complaint, which KKPC filed in April 2008.  Flexsys
moved to dismiss the latest amended complaint and the motion is
pending.





Legal
Proceedings in Europe, Korea, and China





Various
parties, including Sinorgchem and other competitors of Flexsys, have filed
other, separate actions in patent courts in Europe, Korea, and China seeking to
invalidate certain of Flexsys’ patents issued in those
jurisdictions.  Flexsys has also filed a patent infringement action in
Korea to enforce its patents against KKPC.





Legacy
Tort Litigation





Pursuant
to the Amended and Restated Settlement Agreement dated February 28, 2008,
entered into by Solutia and Monsanto in connection with our emergence from
Chapter 11 (the “Monsanto Settlement Agreement”), Monsanto is responsible to
defend and indemnify Solutia for any Legacy Tort Claims as that term is defined
in the agreement, while Solutia retains responsibility for tort claims arising
out of exposure occurring after the Solutia Spinoff.  Solutia and
Flexsys have been named as defendants in the following actions, and have
tendered the matters to Monsanto as Legacy Tort Claims. Solutia and Flexsys
would potentially be liable with respect to these matters to the extent they
relate to post Solutia Spinoff exposure or such matters are not within the
meaning of "Legacy Tort Claims" winthin the Monsanto Settlement
Agreement.





Putnam County, West Virginia
litigation.In December 2004, a purported class action lawsuit was filed
in the Circuit Court of Putnam County, West Virginia against Flexsys, Pharmacia,
Monsanto and Akzo Nobel (Solutia Inc. is not a named defendant) alleging
exposure to dioxin from Flexsys’ Nitro, West Virginia facility, which is now
closed.  The relevant production activities at the facility occurred
during Pharmacia’s ownership and operation of the facility and well prior to the
creation of the Flexsys joint venture between Pharmacia (then known as Monsanto,
whose interest was subsequently transferred to us in the Solutia Spinoff) and
Akzo Nobel.  The plaintiffs are seeking damages for loss of property
value, medical monitoring and other equitable relief.





Beginning
in February 2008, Flexsys, Monsanto, Pharmacia, Akzo Nobel and another third
party were named as defendants in approximately seventy-five individual
lawsuits, and Solutia was named in two individual lawsuits, filed in Putnam
County, West Virginia, by residents of that county.  The largely
identical complaints allege that the residents were exposed to potentially
harmful levels of dioxin particles from the Nitro facility.





20


SOLUTIA
INC.
  NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
  Escambia
County, Florida Litigation. On June 6, 2008, a group of approximately
fifty property owners and business owners in the Pensacola, Florida area filed a
lawsuit in the Circuit Court for Escambia County, Florida against Monsanto,
Pharmacia, Solutia, and the plant manager at Solutia's Pensacola
plant.  The lawsuit, entitled John
Allen, et al. v. Monsanto Company, et al., alleges that the defendants
are responsible for elevated levels of PCBs in the Escambia River and Escambia
Bay due to past and allegedly continuing releases of PCBs from the Pensacola
plant.  The plaintiffs seek: (1) damages associated with alleged
decreased property values caused by the alleged contamination, and
(2) remediation of the alleged contamination in the
waterways.





Cash
Balance Plan Litigation





Since
October 2005, current and former participants in the Solutia Inc. Employees’
Pension Plan (the “Pension Plan”) have filed three class actions alleging that
the Pension Plan is discriminatory based upon age and that the lump sum values
of individual account balances in the Pension Plan have been, and continue to
be, miscalculated.  Solutia has not been named as a defendant in any
of these cases.  Two of these cases, captioned Davis, et al. v. Solutia, Inc.
Employees’ Pension Plan and Hammond, et al. v. Solutia, Inc.
Employees’ Pension Plan, are still pending in the Southern District of
Illinois, and have been consolidated with similar cases against Monsanto Company
and the Monsanto Company Pension Plan (Walker et al. v. The Monsanto
Pension Plan, et al.) and the Pharmacia Cash Balance Pension Plan,
Pharmacia Corporation, Pharmacia and Upjohn, Inc., and Pfizer Inc. (Donaldson v. Pharmacia Cash Balance
Pension Plan, et al.).  The plaintiffs in the Pension Plan
cases seek to obtain injunctive and other equitable relief (including money
damages awarded by the creation of a common fund) on behalf of themselves and
the nationwide putative class of similarly situated current and former
participants in the Pension Plan.





A
Consolidated Class Action Complaint (the “Complaint”) was filed by all of the
plaintiffs in the consolidated case on September 4, 2006.  The
Complaint alleged three separate causes of action against the Pension Plan: (1)
the Pension Plan violates the Employee Retirement Income Security Act (“ERISA”)
by terminating interest credits on prior plan accounts at the age of 55; (2) the
Pension Plan is improperly backloaded in violation of ERISA; and (3) the Pension
Plan is discriminatory on the basis of age.  In September 2007, the
second and third of these claims were dismissed by the court.





By
consent of the parties, the court certified a class with respect to the Pension
Plan on plaintiffs’ claim that the Pension Plan discriminated against employees
on the basis of their age by only providing interest credits on prior plan
accounts through age 55.  Summary judgment motions were filed in the
case on July 11, 2008, and are currently pending.  A trial, if
necessary, would be expected to occur in late 2008.





Department
of Justice Investigations





We
received two grand jury subpoenas from the Antitrust Division of the United
States Department of Justice (the “DOJ”).  The first subpoena, which
we received in April 2006, relates to the DOJ’s investigation of potential
antitrust violations in the adipic acid industry.  The second
subpoena, which we received in September 2007, pertains to the DOJ’s
investigation of potential antitrust violations in the sodium tripoloyphosphate
(“STPP”) industry.  During the relevant time period of the subpoena,
we were an owner of Astaris LLC, a 50/50 joint venture with FMC Corporation,
which manufactured and marketed phosphorus-based products, including
STPP.  We and our joint venture partner sold substantially all of the
assets of Astaris in November 2005 to Israel Chemicals Limited.  We
have not engaged in the STPP business since the sale of our interest in the
Astaris assets.  We are fully cooperating with the DOJ in both
investigations, which are ongoing.





21


SOLUTIA
INC.
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
  LaSalle
Termination Litigation





Solutia
Canada Inc. (“SOCAN”) filed suit in Quebec Court in December 2006, alleging
breach of contract by INEOS Americas LLC (“INEOS”).  In late 2002, we
negotiated a Stock and Asset Purchase Agreement for the sale of our Resimenes
& Additives business to UCB S.A. (“UCB”).  As part of this
agreement, we agreed to exclude the LaSalle assets from the agreement and
entered into the LaSalle Toll Agreement (“LTA”) with UCB.  The LTA
passed through all the benefits and risks of ownership of the LaSalle operations
to UCB, other than pre-closing environmental liabilities.  In the LTA,
SOCAN agreed to operate its LaSalle Plant for the benefit of UCB and to provide
all the necessary services to convert UCB’s raw materials on a cost-neutral
basis.  Thus, UCB would pay SOCAN for all of its actual, direct and
indirect costs incurred in connection with the performance or supply of services
under the LTA or in holding itself ready to perform or supply those
services.  In the years after its execution, the LTA was assigned by
UCB to Cytec Industries, Inc., then to INEOS.





On
January 31, 2006, INEOS notified SOCAN of its intention to terminate the LTA
effective January 31, 2008, in compliance with the terms of the
LTA.  INEOS’ decision to terminate the LTA has triggered the shutdown
of all activities at the LaSalle Plant, resulting in termination costs
recoverable by SOCAN against INEOS.  INEOS disputed and refused to pay
SOCAN’s termination costs under the LTA.





We filed
this litigation against INEOS in December 2006 for breach of the LTA with
respect to such termination costs.  On June 4, 2008, SOCAN submitted
an amended claim to the Court, clarifying and amending SOCAN’s damages claim
against INEOS based on actual costs incurred in connection with the cessation of
operations.  SOCAN’s revised claim alleges approximately $40 in unpaid
damages. INEOS has filed a cross-demand against SOCAN for $1, alleging SOCAN
improperly charged INEOS on its October and November 2006 invoices for items
which INEOS claims are not actual direct or indirect costs under the
LTA.




Concluded
matters





The
matters referred to in our 2007 Form 10-K and Form 10-Q for the period ended
March 31, 2008, as the Ferro
Antitrust Investigationand the Texas Commission on Environmental
Quality Administrative Enforcement Proceeding have concluded pursuant to
the terms described in those filings, and are no longer deemed pending
contingencies.





Environmental
Liabilities





As of
December 31, 2007, we had $78 reserved for the remediation of hazardous
substances at plant sites which we own or operate.  The environmental
remediation obligation for properties we never owned or operated, including
certain locations outside our plant boundaries in Anniston, Alabama, and Sauget,
Illinois (the “Shared Sites”), were classified by us as subject to compromise at
December 31, 2007, as during the bankruptcy proceedings, these obligations were
managed and funded by Monsanto.  At the Effective Date, Monsanto had
spent approximately $79 related to the Shared Sites during the bankruptcy
proceedings.  Of this amount, $29 was classified as an administrative
claim and paid at emergence out of the proceeds of the Creditor Rights
Offering.  In accordance with the Monsanto Settlement Agreement, the
other $50 of funding provided by Monsanto was not reimbursed.  As of
the Effective Date, and under the Monsanto Settlement Agreement and the Plan of
Reorganization, Monsanto accepted responsibility for properties we never owned
or operated and we agreed to share responsibility with Monsanto for the Shared
Sites.  Under this cost-sharing arrangement, we are responsible for
the funding of remediation activities at the Shared Sites from the Effective
Date up to a total of $325.  Thereafter, if needed, we and Monsanto
will share responsibility equally.  The effect of the Monsanto
Settlement Agreement and the Plan of Reorganization, along with the application
of fresh-start accounting, was an increase in our environmental reserve at the
Effective Date of $261, which was recorded by the Predecessor as a charge to
Reorganization items, net.  The increase in the reserve of $261 and $1
of payments during the two months ended February 29, 2008 resulted in
a total reserve of $338 as of March 1, 2008 which relates to all sites
managed by us.  The amounts reserved related to the Shared Sites is
significantly less than the $325 threshold in which we would begin to share
future costs with Monsanto.





22


SOLUTIA
INC.
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
  As of June 30, 2008, we
had $338 reserved for environmental matters.  This amount represents
our best estimate of our share of costs likely to be incurred at those sites
where costs are reasonably estimable based on our analysis of the extent of
clean up required, alternative clean up methods available, abilities of other
responsible parties to contribute and our interpretation of laws and regulations
applicable to each site.  On a periodic basis, we reassess these
reserves to determine if environmental circumstances have changed and/or
remediation efforts and our estimate of related costs have
changed.  As a result of these reassessments, future charges to income
may be necessary, which could have a material effect on our consolidated
liquidity and profitability.  The range of probable outcomes could be
approximately $20 lower than the recorded amount and up to $160 beyond the
amount accrued.





11.  Pension
Plans and Other Postretirement Benefits





During
our Chapter 11 Cases, we amended our U.S. qualified pension plan in 2004 and
2005 to cease future benefit accruals for union and non-union participants,
respectively, in these plans which eliminated service costs for benefits earned
as a pension benefit cost.  Furthermore, we amended our U.S.
postretirement plan in accordance with the Plan for retiree participants and
established a VEBA retiree trust at the Effective Date.  The
postretirement plan amendment, which became effective on the Effective Date,
reduces the eligible charges covered by the postretirement plan and establishes
a lifetime maximum benefit.  This action resulted in a curtailment of
the U.S. postretirement plan, as defined by SFAS No. 106, Employers’ Accounting for
Postretirement Benefits Other Than Pensions(“SFAS No. 106”), due to the
changes in medical benefits provided to retiree participants in our U.S.
postretirement plan.  The net result of this action was
a $109 gain recorded in Accumulated Other Comprehensive Loss in the
Consolidated Statement of Financial Position as of February 29,
2008.  As described in Note 2, upon the adoption of fresh-start
accounting, the balance in Accumulated Other Comprehensive Loss in the
Consolidated Statement of Financial Position was reduced to zero and charged to
Reorganization Items, net.  The VEBA retiree trust, valued at $195 as
of February 29, 2008 as funded by proceeds from the sale of New Common Stock and
a contribution of the retirees’ allowed unsecured claim, effectuates defeasance
of a substantial amount of the remaining healthcare and other benefits
liabilities assumed by us at the Solutia Spinoff.




Components
of Net Periodic Benefit Cost





For the three months ended June 30,
2008 and 2007, the two months ended February 29, 2008 and the four and six
months ended June 30, 2008 and 2007, respectively, our pension and healthcare
and other benefit costs were as follows:





Pension BenefitsSuccessor
            
            
            Predecessor
            
            
            Successor
            
            
            PredecessorThree
      Months
              Ended
              June
      30,
              2008
            
            
            Three
      Months
              Ended
              June
      30,
              2007
            
            
            Four
      Months
              Ended
              June
      30,
              2008
            
            
            Two
      Months
              Ended
              February
      29,
              2008
            
            
            Six
      Months
              Ended
              June
      30,
              2007Service
      costs for benefits earned
            
            $
            1
            
            
            $
            2
            
            
            $
            1
            
            
            $
            1
            
            
            $
            2Interest
      costs on benefit obligation
            
            
            17
            
            
            
            17
            
            
            
            23
            
            
            
            12
            
            
            
            34Assumed
      return on plan assets
            
            
            (19
            )
            
            
            (18
            )
            
            
            (25
            )
            
            
            (13
            )
            
            
            (35
            )Actuarial
      net loss
            
            
            --
            
            
            
            3
            
            
            
            --
            
            
            
            2
            
            
            
            5Settlement
      charge
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            1
            
            
            
            --Total
            
            $
            (1
            )
            
            $
            4
            
            
            $
            (1
            )
            
            $
            3
            
            
            $
            6





23


SOLUTIA
INC.
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
  Healthcare and Other
    BenefitsSuccessor
            
            
            Predecessor
            
            
            Successor
            
            
            PredecessorThree
      Months
              Ended
              June
      30,
              2008
            
            
            Three
      Months
              Ended
              June
      30,
              2007
            
            
            Four
      Months
              Ended
              June
      30,
              2008
            
            
            Two
      Months
              Ended
              February
      29,
              2008
            
            
            Six
      Months
              Ended
              June
      30,
              2007Service
      costs for benefits earned
            
            $
            1
            
            
            $
            1
            
            
            $
            2
            
            
            $
            1
            
            
            $
            2Interest
      costs on benefit obligation
            
            
            4
            
            
            
            6
            
            
            
            5
            
            
            
            4
            
            
            
            12Assumed
      return on plan assets
            
            
            (1
            )
            
            
            --
            
            
            
            (2
            )
            
            
            --
            
            
            
            --Prior
      service credits
            
            
            --
            
            
            
            (4
            )
            
            
            --
            
            
            
            (3
            )
            
            
            (8
            )Actuarial
      net loss
            
            
            --
            
            
            
            2
            
            
            
            --
            
            
            
            --
            
            
            
            4Total
            
            $
            4
            
            
            $
            5
            
            
            $
            5
            
            
            $
            2
            
            
            $
            10





Settlements





We
recorded a pension settlement charge of $1 in the two months ended February 29,
2008 resulting from the significant amount of lump sum distributions from our
Belgium retirement plan.





Employer Contributions





According
to IRS funding rules, we will be required to make approximately $54 in pension
contributions to our U.S. qualified pension plan in 2008.  We made $26
of these required 2008 contributions during the six months ended June 30,
2008.  We also expect to be required to fund approximately $5 in
pension contributions to our foreign pension plans in 2008.





24


SOLUTIA
INC.
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
 12.  Debt
Obligations





Our
long-term debt consisted of the following as of June 30, 2008 and December 31,
2007:





Successor
            
            
            PredecessorJune
      30,
              2008
            
            
            December
      31,
              2007Senior
      secured term loan facility due 2014
            
            $
            1,194
            
            
            $
            --Senior
      secured asset-based revolving credit facility due 2013
            
            
            181
            
            
            
            --15.50%
      senior unsecured bridge facility due 2015
            
            
            405
            
            
            
            --6.72%
      debentures due 2037
            
            
            --
            
            
            
            15011.25%
      notes due 2009
            
            
            --
            
            
            
            223Facility
      Agreement due 2011
            
            
            --
            
            
            
            2317.375%
      debentures due 2027
            
            
            --
            
            
            
            300Flexsys
      term loan due 2012
            
            
            --
            
            
            
            76Flexsys
      revolving credit facility due 2012
            
            
            --
            
            
            
            47Maryville
      notes due 2022
            
            
            --
            
            
            
            20Total principal
      amount
            
            
            1,780
            
            
            
            1,047Unamortized
      net discount (a)
            
            
            --
            
            
            
            --1,780
            
            
            
            1,047Less
      current portion of long-term debt
            
            
            (12
            )
            
            
            (15
            )Less
      amounts subject to compromise (Note 2)
            
            
            --
            
            
            
            (673
            )Total
            
            $
            1,768
            
            
            $
            359





(a)
            Unamortized
      net discount of $14 as of December 31, 2007 is included in
      liabilities subject to compromise, as further described in Note
      2.





Financing
Agreements





On the
Effective Date, we entered into the Financing Agreements to borrow up to $2.05
billion from the Lenders.  Proceeds from the Financing Agreements and
existing cash were used to (i) repay the DIP credit facility, (ii) retire
Solutia Services International S.C.A./Comm. V.A.’s (“SSI”) Facility Agreement
due 2011, (iii) retire the Flexsys term loan and revolving credit facility due
2012, (iv) pay certain secured and administrative claims, and (v) provide
additional liquidity for operations.





The
Financing Agreements consist of (i) a $450 senior secured asset-based revolving
credit facility which is comprised of a U.S Facility and a Belgium Facility
(“Revolver”), (ii) a $1.2 billion senior secured term loan facility (“Term
Loan”) and (iii) a $400 senior unsecured bridge facility
(“Bridge”).





The
Revolver bears interest, at our option, at LIBOR or the prime rate plus an
applicable margin.  As of June 30, 2008, the applicable margin for the
LIBOR and prime rate loans in the Revolver are 1.75 percent and 0.75 percent,
respectively.  The Term Loan bears interest at LIBOR, with a floor of
3.50 percent through the fourth anniversary of the Effective Date, plus 5.00
percent.  Interest for the Revolver and Term Loan is payable (i) with
respect to LIBOR loans, on the last day of each relevant interest period
(defined as one, two, three or six months or any longer period available to all
Lenders under each facility) and, in the case of any interest period longer than
three months, on each successive date three months after the first day of such
interest period, and (ii) with respect to prime rate loans, quarterly in
arrears.





The
Bridge has a fixed interest rate of 15.50 percent with interest payable
quarterly.  For the period commencing on the Effective Date and ending
on the day immediately preceding the first anniversary of the Effective Date, no
more than 3.50 percent per annum may be paid in the form of payment-in-kind
interest; for the period commencing on the first anniversary of the Effective
Date and ending on the day immediately preceding the second anniversary of the
Effective Date, no more than 2.50 percent per annum may be paid in the form of
payment-in-kind interest; and commencing on the second anniversary of the
Effective Date and thereafter, no more than 1.50 percent per annum may be paid
in the form of payment-in-kind interest.





25





SOLUTIA
INC.
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
  Our current subsidiaries CPFilms Inc., Flexsys America L.P., Flexsys America
Co., Monchem International, Inc., Solutia Business Enterprises Inc., Solutia
Greater China, Inc., Solutia Inter-America, Inc., Solutia Overseas, Inc.,
Solutia Systems, Inc., Beamer Road Management Company and future subsidiaries as
defined by the Financing Agreements, subject to certain exceptions (the
“Guarantors”) are guarantors of our obligations under the Financing
Agreements.  On May 5, 2008, Solutia formed a 100% owned subsidiary
named S E Investment LLC which was added as a guarantor.  The
Financing Agreements and the related guarantees are secured by liens on
substantially all of our and the Guarantors’ present and future
assets.





We are
required to make mandatory repayments of the Financing Agreements in connection
with asset sales, equity issuance and certain other events.  We are
required to pay 1 percent of the principal of the Term Loan annually via
quarterly payments.  In addition, on an annual basis and subject to
our leverage position at December 31st of each year, we are required to repay
the Term Loan with 25 percent or 50 percent of the excess cash generated during
the year as defined in the Financing Agreements.  Any portion of the
Term Loan that is repaid through mandatory prepayments or voluntarily repaid may
not be reborrowed.  Furthermore, voluntary prepayments or amendments
to the Term Loan are subject to a prepayment premium or fee of 3 percent of the
principal amount prepaid or principal amount outstanding, respectively, prior to
the first anniversary of the Effective Date, 2 percent after the first
anniversary and prior to the second anniversary of the Effective Date and 1
percent after the second anniversary and prior to the third anniversary of the
Effective Date.  We are not subject to any prepayment premiums or fees
for amendments after the third anniversary of the Effective Date.





The
Financing Agreements include a number of customary covenants and events of
default, including the maintenance of certain financial covenants that
restrict our ability to, among other things, incur additional debt; make certain
investments; pay dividends, repurchase stock, sell certain assets or merge with
or into other companies; enter into new lines of business; make capital
expenditures; and prepay, redeem or exchange our debt.  The financial
covenants are (i) total leverage ratio, (ii) fixed charge coverage ratio and
(iii) a capital expenditure cap as defined by the Financing
Agreements.  We were in compliance with all applicable covenants as of
June 30, 2008.





Maryville
Notes





On June
24, 2008, we completed the sale and leaseback of our corporate headquarters for
$43 and repaid the $19 remaining on the Maryville Notes on that date from the
proceeds.




13.  Segment
Data





We are a
global manufacturer and marketer of a variety of high-performance chemical-based
materials, which are used in a broad range of consumer and industrial
applications.  Prior to the first quarter of 2008, we managed our
businesses in the following four operating segments:  CPFilms, Other
Performance Products (“OPP”), Rubber Chemicals and Integrated
Nylon.  As allowed by SFAS No. 131, Disclosures about Segments of an
Enterprise and Related Information, the CPFilms, OPP and Rubber Chemicals
operating segments were aggregated into one reportable segment titled
Performance Products.  In the first quarter of 2008, we realigned the
OPP operating segment whereby SAFLEX® is evaluated discretely by our chief
operating decision maker and the aviation and heat transfer products are
combined with the Rubber Chemicals business and titled Technical Specialties,
when reviewed by our chief operating decision maker.  In concurrence
with this realignment, we have ceased the aggregation of the above into the
Performance Products reportable segment and have chosen to report the operating
segments separately.  Therefore, beginning in the first quarter of
2008, we report our businesses consistent with our four operating
segments:  SAFLEX®, CPFilms, Technical Specialties and Integrated
Nylon.





The
SAFLEX® reportable segment is a global manufacturer of performance films for
laminated safety glass.  The CPFilms reportable segment is a
manufacturer of performance films for after-market applications which add
functionality to glass.  The Technical Specialties reportable segment
is a global manufacturer of specialty products such as chemicals for the rubber
industry, heat transfer fluids and aviation hydraulic fluids.  The
Integrated Nylon reportable segment consists of an integrated family of nylon
products including high-performance polymers and fibers.  The major
products by reportable segment are as follows:





26
 SOLUTIA
INC.
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)


Reportable
      Segment
            ProductsSAFLEX®
            ·SAFLEX®
      plastic interlayer
              ·Specialty
      intermediate Polyvinyl Butyral resin and plasticizerCPFilms
            ·LLUMAR®,
      VISTA®, GILA® and FORMULA ONE PERFORMANCE AUTOMOTIVE FILMS®
              professional
      and retail window films
              ·Other
      enhanced polymer films for industrial customersTechnical
      Specialties
            ·CRYSTEX®
      insoluble sulphur
              ·SANTOFLEX®
      antidegradants
              ·SANTOCURE®
      and PERKACIT® primary accelerators
              ·THERMINOL®
      heat transfer fluids
              ·SKYDROL®
      aviation hydraulic fluids
              ·SKYKLEEN®
      brand of aviation solventsIntegrated
      Nylon
            ·Nylon
      intermediate “building block” chemicals
              ·Nylon
      polymers, including VYDYNE® and
      ASCEND®
              ·Carpet
      fibers, including the WEAR-DATED® and
      ULTRON®
      brands
              ·Industrial
      nylon fibers





Beginning
with the first quarter of 2008, the performance of our operating segments is
evaluated based on segment profit, defined as earnings before interest expense,
income taxes, depreciation and amortization, and reorganization items, net
(“EBITDA”).  Prior to the first quarter of 2008, segment profit was
defined as earnings before interest expense and income taxes
(“EBIT”).  Segment profit includes selling, general and
administrative, research, development and other operating expenses, gains and
losses from asset dispositions and restructuring charges, and other income and
expense items that can be directly attributable to the
segment.  Certain operations, expenses and other items that are
managed outside the reportable segments are reported as Unallocated and
Other.  Unallocated and Other is comprised of corporate expenses,
adjustments to our LIFO valuation reserve, equity earnings from affiliates,
other income and expense items, gains and losses from asset dispositions and
restructuring charges that are not directly attributable to the reportable
segments and operating segments that do not meet the quantitative threshold for
determining reportable segments.  All prior periods have been
retroactively presented for the changes in reportable segments and measurement
of segment profit.  There were no inter-segment sales in the periods
presented below.








27




SOLUTIA
INC.
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
  Segment data for the three
months ended June 30, 2008 and 2007, the two months ended February 29, 2008 and
the four and six months ended June 30, 2008 and 2007, respectively are as
follows:





Successor
            
            
            PredecessorThree
      Months
              Ended
              June
      30,
              2008
            
            
            Three
      Months
              Ended
              June
      30,
              2007Net
              Sales
            
            
            Profit
              (Loss)
            
            
            Net
              Sales
            
            
            Profit
              (Loss)Reportable
      Segments:SAFLEX®
            
            $
            220
            
            
            $
            19
            
            
            $
            189
            
            
            $
            31CPFilms
            
            
            71
            
            
            
            16
            
            
            
            66
            
            
            
            20Technical
      Specialties
            
            
            275
            
            
            
            39
            
            
            
            157
            
            
            
            20Integrated
      Nylon
            
            
            518
            
            
            
            (1
            )
            
            
            489
            
            
            
            38Reportable
      Segment Totals
            
            
            1,084
            
            
            
            73
            
            
            
            901
            
            
            
            109Unallocated
      and Other
            
            
            11
            
            
            
            (6
            )
            
            
            10
            
            
            
            1Total
            
            
            1,095
            
            
            
            67
            
            
            
            911
            
            
            
            110Reconciliation
      to Consolidated Totals:Depreciation
      and amortization
            
            
            
            
            
            
            (35
            )
            
            
            
            
            
            
            (28
            )Interest
      expense
            
            
            
            
            
            
            (48
            )
            
            
            
            
            
            
            (31
            )Reorganization
      items, net
            
            
            
            
            
            
            --
            
            
            
            
            
            
            
            (17
            )Consolidated
      Totals:Net
      Sales
            
            $
            1,095
            
            
            
            
            
            $
            911Income
      (Loss) from Continuing
              Operations
      Before Income Taxes
            
            
            
            
            
            $
            (16
            )
            
            
            
            
            
            $
            34





Successor
            
            
            PredecessorFour
      Months
              Ended
              June
      30,
              2008
            
            
            Two
      Months
              Ended
              February
      29,
              2008
            
            
            Six
      Months
              Ended
              June
      30,
              2007Net
              Sales
            
            
            Profit
              (Loss)
            
            
            Net
              Sales
            
            
            Profit
              (Loss)
            
            
            Net
              Sales
            
            
            Profit
              (Loss)Reportable
      Segments:SAFLEX®
            
            $
            288
            
            
            $
            22
            
            
            $
            125
            
            
            $
            17
            
            
            $
            358
            
            
            $
            59CPFilms
            
            
            94
            
            
            
            19
            
            
            
            39
            
            
            
            9
            
            
            
            125
            
            
            
            36Technical
      Specialties
            
            
            363
            
            
            
            51
            
            
            
            164
            
            
            
            40
            
            
            
            195
            
            
            
            28Integrated
      Nylon
            
            
            668
            
            
            
            (12
            )
            
            
            318
            
            
            
            2
            
            
            
            916
            
            
            
            66Reportable
      Segment Totals
            
            
            1,413
            
            
            
            80
            
            
            
            646
            
            
            
            68
            
            
            
            1,594
            
            
            
            189Unallocated
      and Other
            
            
            14
            
            
            
            (13
            )
            
            
            7
            
            
            
            (4
            )
            
            
            19
            
            
            
            (11
            )Total
            
            
            1,427
            
            
            
            67
            
            
            
            653
            
            
            
            64
            
            
            
            1,613
            
            
            
            178Reconciliation
      to Consolidated Totals:Depreciation and
      amortization
            
            
            
            
            
            
            (47
            )
            
            
            
            
            
            
            (20
            )
            
            
            
            
            
            
            (53
            )Interest
expense
            
            
            
            
            
            
            (66
            )
            
            
            
            
            
            
            (21
            )
            
            
            
            
            
            
            (59
            )Reorganization items,
      net
            
            
            
            
            
            
            --
            
            
            
            
            
            
            
            1,642
            
            
            
            
            
            
            
            (33
            )Consolidated
      Totals:Net
      Sales
            
            $
            1,427
            
            
            
            
            
            $
            653
            
            
            
            
            
            $
            1,613Income
      (Loss) from Continuing
              Operations
      Before Income Taxes
            
            
            
            
            
            $
            (46
            )
            
            
            
            
            
            $
            1,665
            
            
            
            
            
            
            $
            33








28




SOLUTIA
INC.
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
 (Dollars
in millions, except per share amounts or otherwise noted)
 (Unaudited)
  The effects of fresh-start
accounting created a material change in total assets by segment when compared to
December 31, 2007.  Total assets by segment at June 30, 2008 and
December 31, 2007 are as follows:





Successor
            
            
            PredecessorJune
      30,
              2008
            
            
            December
      31,
              2007Assets
            
            
            AssetsReportable
      Segments:SAFLEX®
            
            $
            1,409
            
            
            $
            525CPFilms
            
            
            644
            
            
            
            255Technical
    Specialties
            
            
            1,068
            
            
            
            635Integrated Nylon
            
            
            1,155
            
            
            
            1,006Reportable
      Segment Totals
            
            $
            4,276
            
            
            $
            2,421Reconciliation
      to consolidated totals:Discontinued
      Operations
            
            
            --
            
            
            
            7Unallocated
      and Other
            
            
            447
            
            
            
            212Consolidated
      Totals
            
            $
            4,723
            
            
            $
            2,640





14.  Earnings
(Loss) Per Share





The following table presents the net
income (loss) used in the basic and diluted earnings (loss) per share and
reconciles weighted-average number of shares used in the basic earnings (loss)
per share calculation to the weighted-average number of shares used to compute
diluted earnings (loss) per share.





Successor
            
            
            Predecessor
            
            
            Successor
            
            
            PredecessorThree
      Months
              Ended
              June
      30,
              2008
            
            
            Three
      Months
              Ended
              June
      30,
              2007
            
            
            Four
      Months
              Ended
              June
      30,
              2008
            
            
            Two
      Months
              Ended
              February
      29,
              2008
            
            
            Six
      Months
              Ended
              June
      30,
              2007Consolidated
      Statement of Operations Results:Income
      (loss) from continuing operations
            
            $
            (16
            )
            
            $
            27
            
            
            $
            (46
            )
            
            $
            1,450
            
            
            $
            19Income
      from discontinued operations
            
            
            --
            
            
            
            29
            
            
            
            --
            
            
            
            --
            
            
            
            29Net
      income (loss)
            
            $
            (16
            )
            
            $
            56
            
            
            $
            (46
            )
            
            $
            1,450
            
            
            $
            48Weighted-average
      number of shares outstanding used for basic earnings (loss) per
      share
            
            
            59.8
            
            
            
            104.5
            
            
            
            59.8
            
            
            
            104.5
            
            
            
            104.5Non-vested
      restricted shares
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --Stock
      options
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --Warrants
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --Weighted-average
      number of shares outstanding and common equivalent shares used for diluted
      earnings (loss) per share
            
            
            59.8
            
            
            
            104.5
            
            
            
            59.8
            
            
            
            104.5
            
            
            
            104.5





Stock options and Warrants to purchase
approximately 2.9 million shares and 4.5 million shares, respectively, and
non-vested restricted shares of 1.5 million were not included in the computation
of earnings (loss) per share since the result would have been antidilutive for
the three and four months ended June 30, 2008.








29







Item
2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS


This
section includes forward-looking statements within the meaning of Section 27A of
the Securities Act of 1933 and Section 21E of the Securities Exchange Act of
1934.  These forward-looking statements include all statements
regarding expected future financial position, results of operations,
profitability, cash flows and liquidity.  Important factors that could
cause actual results to differ materially from the expectations reflected in the
forward-looking statements herein include, among others, our ability to comply
with the terms of our Financing Agreements, our ability to reduce our overall
leveraged position, general economic, business and market conditions; customer
acceptance of new products; raw material and energy costs or shortages; limited
access to capital resources; currency and interest rate fluctuations; increased
competitive and/or customer pressure; gain or loss of significant customers;
compression of credit terms with suppliers; exposure to product liability and
other litigation; changes in cost of environmental remediation obligations and
other environmental liabilities; changes in accounting principles generally
accepted in the U.S.; ability to implement cost reduction initiatives in a
timely manner; geopolitical instability; and changes in pension and other
postretirement assumptions.





Overview





We are a
leading global manufacturer and marketer of a variety of high-performance
chemical and engineered materials that are used in a broad range of consumer and
industrial applications.  In the first quarter of 2008, we consummated
our reorganization under the Bankruptcy Code and emerged from bankruptcy
concurrent with entering into financing agreements with certain lenders to
borrow up to $2.05 billion.





We
currently report our operations in four segments: SAFLEX®, CPFilms, Technical
Specialties and Integrated Nylon.  The major products by reportable
segment are as follows:





Reportable
      Segment
            ProductsSAFLEX®
            ·SAFLEX®
      plastic interlayer
              ·Specialty
      intermediate Polyvinyl Butyral resin and plasticizerCPFilms
            ·LLUMAR®,
      VISTA®, GILA® and FORMULA ONE PERFORMANCE AUTOMOTIVE FILMS®
              professional
      and retail window films
              ·Other
      enhanced polymer films for industrial customersTechnical
      Specialties
            ·CRYSTEX®
      insoluble sulphur
              ·SANTOFLEX®
      antidegradants
              ·SANTOCURE®
      and PERKACIT® primary accelerators
              ·THERMINOL®
      heat transfer fluids
              ·SKYDROL®
      aviation hydraulic fluids
              ·SKYKLEEN®
      brand of aviation solventsIntegrated
      Nylon
            ·Nylon
      intermediate “building block” chemicals
              ·Nylon
      polymers, including VYDYNE® and
      ASCEND®
              ·Carpet
      fibers, including the WEAR-DATED® and
      ULTRON®
      brands
              ·Industrial
      nylon fibers





See Note 13 to the accompanying
consolidated financial statements for further information regarding our
reportable segments.





Strategic
Actions Initiated in the Second Quarter 2008





To meet increasing demand for polyvinyl
butyral (PVB) sheet, which Solutia markets under the SAFLEX® brand name, in
the second quarter of 2008 we announced capital projects to expand our PVB resin
manufacturing operations at our facilities located in Springfield, Massachusetts
and Antwerp, Belgium.  PVB resin is the key raw material used in the
manufacturing of our SAFLEX® plastic interlayer.  Expected to be on
line in 2009 (Springfield) and 2010 (Antwerp), the resin capacity expansions at
these facilities will be necessary to meet the growing global demand of
SAFLEX®.





30


Consistent with our portfolio strategy
of strengthening our business with products holding market leading positions and
limiting exposure in product lines where we are not cost competitive, during the
second quarter, we announced the expected closure of our manufacturing facility
in Ruabon, Wales, United Kingdom (the “Ruabon Facility”).  The
manufacture of SANTOGARD® pre-vulcanization
inhibitors, PERKACIT® DPG, which is
used as a secondary accelerator in the rubber vulcanization process, and
FLECTOL® TMQ
and FLECTOL®
HPG, which protect against oxidative aging, is expected to cease by the end of
2008.  Complete closure of the Ruabon Facility is expected by the end
of 2011.  The decision to cease manufacturing of the product lines at
the Ruabon Facility is due to an over-supplied market resulting from higher
competition from principally Far Eastern producers, resulting in the Ruabon
Facility no longer being cost competitive on a global scale.  We
expect to incur charges of approximately $45 million to $60 million related to
the exit of the Ruabon Facility between now and final closure in
2011.





We have retained HSBC Securities (USA)
Inc. to explore strategic alternatives for our Integrated Nylon business,
including a possible sale.  We believe strongly in the strategic
course we have set for the business. However, given the strength of our
high-margin specialty chemical and performance materials businesses and the
current industry dynamic in the nylon segment, we believe that it is an
appropriate time to explore strategic alternatives available with respect to the
Integrated Nylon business that would better position both the business and the
rest of Solutia for reaching their ultimate potential.No
assurances can be made as to whether the exploration of strategic alternatives
will lead to the consummation of any particular transaction, which would likely
be subject to numerous closing conditions including, but not limited to, various
third party approvals, including approvals under our financing
agreements.





Combined
Quarterly Financial Results of the Predecessor and Successor




Our
emergence from bankruptcy resulted in our adoption of fresh-start accounting on
February 29, 2008.  In accordance with Generally Accepted Accounting
Principles, the accompanying Consolidated Statements of Operations and Cash
Flows presents the results of operations and the sources and uses of cash for
(i) the two months ended February 29, 2008 of the Predecessor and (ii) the four
months ended June 30, 2008 of the Successor.  However, for purposes of
management’s discussion and analysis of the results of operations and the
sources and uses of cash in this Form 10-Q, we have combined the current year
results of operations for the Predecessor and the Successor.  The
results of operations of the Predecessor and Successor are not comparable due to
the change in basis resulting from the emergence from bankruptcy.  The
combined presentation is being made solely to explain the changes in results of
operations for the periods presented in the financial statements. We then
compare the combined results of operations and the sources and uses of cash for
the six months ended June 30, 2008 with the corresponding period in the prior
year.





An
additional impact to comparability of segment profit resulting from our
emergence from bankruptcy and the implementation of fresh-start accounting is
the change in depreciation and amortization and the elimination of Chapter 11
reorganization expenses on a post-emergence basis.  Therefore,
effective with the first quarter of 2008,management evaluatedthe
performance of our operating segments based on segment profit, defined as
earnings before interest expense, income taxes, depreciation and amortization,
and reorganization items (“EBITDA”) which includes selling, general and
administrative, research, development and other operating expenses, gains and
losses from asset dispositions and restructuring charges, and other income and
expense items that can be directly attributable to the segment.  To
the extent each segment’s EBITDA is materially impacted by fresh-start
accounting or other differences exist between Predecessor and Successor, these
differences are identified in the discussion of results.





We believe the combined results of
operations for the three and six months ended June 30, 2008 provide management
and investors with a more meaningful perspective on our ongoing financial and
operational performance and trends than if we did not combine the results of
operations of the Predecessor and the Successor in this
manner.  Further, the use of EBITDA as the earnings metric allows for
meaningful analysis across both periods.





31


Summary
Results of Operations





In the
second quarter of 2008, we reported sales of $1,095 million, a 20 percent
increase over $911 million reported in the second quarter of 2007. The increase
was driven by acquisitions, higher selling prices, higher demand, and favorable
currency exchange rate fluctuations.  Our second quarter of 2008 gross
profit of $109 million, a 12 percent decrease versus the same period in
2007, and our gross profit margin of 10.0 percent, a decrease from 13.6 percent
versus the same period in 2007, were both significantly impacted by the
recognition into cost of goods sold the step-up in basis of our inventory of $49
million recorded in accordance with fresh-start accounting.  Excluding
this charge, higher raw material, energy and freight costs, were offset by the
Flexsys acquisition and the combination of higher selling prices, increased
demand, and favorable currencies.  Selling, general and administrative
expenses remained at approximately 7 percent of sales, consistent with
2007.  In total, this quarter’s operating income results include
$52 million of negative impacts from non-operational or non-recurring
items.





In the
six months ended June 30, 2008, we reported sales of $2,080 million, a 29
percent increase over $1,613 million reported in the same period in
2007.  The increase was driven by acquisitions, higher selling prices,
higher demand, and favorable currency exchange rate
fluctuations.  Gross profit of $223 million in the six months
ended June 30, 2008 was 2 percent lower than the same period in
2007.  Higher raw material, energy and freight costs and the impacts
of fresh-start accounting were partially offset by the Flexsys acquisition and
the combination of higher selling prices, increased demand, and favorable
currencies.  Gross profit margin in the six months ended June 30, 2008
decreased to 10.7 percent from 14.1 percent in the prior year period, due to the
factors previously noted.  Selling, general and administrative
expenses remained at approximately 8 percent of sales, consistent with
2007.  The six months ended June 30, 2008 operating income results
also include $75 million of negative impacts from the adoption of
fresh-start accounting as of the Effective Date and other non-operational or
non-recurring items.





We used
$437 million of cash from operations in the six months ended June 30, 2008, due
to outflows required to facilitate emergence from bankruptcy, the seasonal build
of working capital and funding into our domestic pension plan.  This
compares to a usage of $115 million in the same period in 2007, which was
primarily due to seasonal working capital build and domestic pension
funding.  Our liquidity at the end of the second quarter was $242
million in the form of $195 million of availability under the Revolver and $47
million of cash on-hand.





Critical
Accounting Policies and Estimates





As a
result of our emergence from bankruptcy and the discharge of many of our legal
proceedings in accordance with the Plan (as described in Note 10 to the
accompanying consolidated financial statements), we no longer consider
Self-Insurance to be a critical accounting policy as we believe it is less
likely to have a material impact on our reported results of operations in future
periods.  There have been no other changes in 2008 with respect to our
critical accounting policies, as presented in our 2007 Form 10-K, as re-casted
and filed with the Securities and Exchange Commission (“SEC”) in a Form 8-K on
July 25, 2008, to reflect our segment reporting change as described in Note 13
to the accompanying consolidated financial statements.





Results
of Operations—Second Quarter 2008 Compared with Second Quarter 2007





Consolidated
Results





Successor
            
            
            Predecessor(dollars
      in millions)
            
            Three
      Months
              Ended
              June
      30,
              2008
            
            
            Three
      Months
              Ended
              June
      30,
              2007
            
            
            Increase
              (Decrease)
            
            
            %
              Increase
              (Decrease)Net
      Sales
            
            $
            1,095
            
            
            $
            911
            
            
            $
            184
            
            
            
            20
            %Operating
      Income:Reportable
      Segment Profit
            
            $
            73
            
            
            $
            109
            
            
            $
            (36
            )
            
            
            (33
            %)Unallocated
      and Other
            
            
            (6
            )
            
            
            1
            
            
            
            (7
            )
            
            N.M.Less:   Depreciation
      and Amortization
            
            
            (35
            )
            
            
            (28
            )Less:   Equity
      Earnings from Affiliates and Other Income included in Segment Profit
      (Loss) and Unallocated and Other
            
            
            (6
            )
            
            
            (28
            )Operating
      Income
            
            $
            26
            
            
            $
            54
            
            
            $
            (28
            )
            
            
            (52
            %)Gains
      (Charges) included in Operating Income
            
            $
            (52
            )
            
            $
            4





32


The
increase in net sales as compared to the second quarter 2007 resulted from our
acquisition of Akzo Nobel’s 50 percent interest in the Flexsys joint venture,
which was completed on May 1, 2007 (the “Flexsys Acquisition”), higher sales
volumes, increased selling prices and the effect of favorable exchange rate
fluctuations.  Prior to May 1, 2007, the results of Flexsys were
accounted for using the equity method and recorded as Equity Earnings from
Affiliates on the Consolidated Statement of Operations.  Net sales
increased $78 million or 8 percent in the second quarter 2008 as a result of the
Flexsys Acquisition.  The remaining $106 million or 12 percent
increase in net sales was a result of higher average selling prices of $78
million or 9 percent and favorable currency exchange rate fluctuations of $28
million or 3 percent.  Higher average selling prices were experienced
across all reporting segments given the generally favorable supply/demand
profile in these markets, new product introductions in certain of our growth
segments and in response to an escalating raw material profile. The
favorable currency benefit was driven most notably by the continued
strengthening of the Euro versus the U.S. dollar, in comparison to the prior
year.  Other currency movements against the U.S. dollar also benefited
our net sales, however, given the strong market positions in Europe within
SAFLEX® and Technical Specialties, movements in the Euro versus the U.S. dollar
had the most significant impact on our revenues.  Higher sales volumes
were experienced in our SAFLEX®, Technical Specialties and CPFilms reporting
segments, given the continued growing global demand for these
products.  However, overall sales volumes were flat as decreases in
Integrated Nylon offset the volume increases in the other
segments.  Within Integrated Nylon, we experienced increased volumes
for nylon plastics and polymers which were more than offset by volume declines
in carpet fibers and intermediate chemicals.





The
decrease in operating income as compared to the second quarter 2007 resulted
from higher charges of $56 million.  Factors that improved operating
income over the prior year were the impact of the Flexsys Acquisition, increased
net sales, higher asset utilization in our SAFLEX® and Technical Specialties
reporting segments and lower LIFO expense.  Partially offsetting these
factors were higher raw material and energy costs of approximately $100 million
and higher logistic costs in Integrated Nylon.  As indicated in the
preceding table, operating results were affected by various charges which are
described in greater detail within this section below.  The raw
material impacts were most significant within the Integrated Nylon segment, with
material increases experienced in the cost of natural gas along with key
feedstocks of propylene and ammonia.  The increases in these raw
materials are primarily driven by continued tight supply of these materials, as
well as the substantial increases in oil prices when compared with the prior
year, second quarter.  We have and will continue to increase selling
prices in response to these material movements although we do experience a lag
in the selling price movements versus raw material movements.





SAFLEX®





Successor
            
            
            Predecessor(dollars
      in millions)
            
            Three
      Months
              Ended
              June
      30,
              2008
            
            
            Three
      Months
              Ended
              June
      30,
              2007
            
            
            Increase
              (Decrease)
            
            
            %
              Increase
              (Decrease)Net
      Sales
            
            $
            220
            
            
            $
            189
            
            
            $
            31
            
            
            
            16
            %Segment
      Profit
            
            $
            19
            
            
            $
            31
            
            
            $
            (12
            )
            
            
            (39
            %)Charges
      included in Segment Profit
            
            $
            (24
            )
            
            $
            --





The
increase in net sales as compared to the second quarter 2007 was a result of
higher sales volumes of $9 million or 5 percent, higher average selling prices
of $7 million or 3 percent and favorable currency exchange rate fluctuations of
$15 million or 8 percent.  The favorable exchange rate fluctuations
occurred primarily as a result of the weakening U.S. dollar in relation to the
Euro in comparison to the second quarter 2007. Higher sales volumes
experienced in targeted growth markets of Europe and Asia Pacific more than
offset lower sales volumes into the domestic market.  The increased
sales in Asia Pacific were a result of the continued expanding demand for
laminated glass in that market, which was partially supported by our new SAFLEX®
plant in Suzhou, China which opened in the third quarter 2007.





The
decrease in segment profit in comparison to the second quarter 2007 resulted
primarily from the $24 million charge in the second quarter 2008 associated with
the amortization of the step-up in basis of our inventory in accordance with
fresh-start accounting.  Offsetting this charge was overall
improvement in segment profit due to the higher net sales as described above,
improved asset utilization and lower manufacturing costs.  Improved
asset utilization in the second quarter of 2008 was predominantly attributable
to our Antwerp, Belgium manufacturing facility, which experienced a scheduled
maintenance shutdown in the second quarter 2007.  Second quarter 2007
start up expenses for new lines at the Santo Toribio, Mexico and Suzhou, China
manufacturing plants were not recurring in the current year which resulted in
lower manufacturing costs.  The segment also experienced approximately
$7 million of higher raw material costs in comparison to the prior year, which
was recovered through increased selling prices.





33




CPFilms





Successor
            
            
            Predecessor(dollars
      in millions)
            
            Three
      Months
              Ended
              June
      30,
              2008
            
            
            Three
      Months
              Ended
              June
      30,
              2007
            
            
            Increase
              (Decrease)
            
            
            %
              Increase
              (Decrease)Net
      Sales
            
            $
            71
            
            
            $
            66
            
            
            $
            5
            
            
            
            8
            %Segment
      Profit
            
            $
            16
            
            
            $
            20
            
            
            $
            (4
            )
            
            
            (20
            %)Charges
      included in Segment Profit
            
            $
            (6
            )
            
            $
            --





The
increase in net sales as compared to the second quarter 2008 resulted primarily
from higher sales volumes of $4 million or 6 percent and higher average selling
prices of $1 million or 2 percent.  The increase in sales volumes
primarily resulted from strong growth in CPFilms’ international window film
markets, most notably South Africa and the Middle East, continued growth of the
industrial business, and moderate growth in North America despite the
challenging macro-economic conditions specific to this market.





The
decrease in segment results in comparison to the second quarter 2007 resulted
primarily from the $6 million charge in the second quarter 2008 associated
with the amortization of the step-up in basis of our inventory in accordance
with fresh-start accounting.  Offsetting this charge was improvement
in segment profit due to higher net sales as described above, partially offset
by continued increased investment in sales and marketing infrastructure and in
market development programs globally.  We believe continued investment
in the sales and marketing infrastructure for this segment will expand the
overall global window film market along with our participation.





Technical
Specialties





Successor
            
            
            Predecessor(dollars
      in millions)
            
            Three
      Months
              Ended
              June
      30,
              2008
            
            
            Three
      Months
              Ended
              June
      30,
              2007
            
            
            Increase
              (Decrease)
            
            
            %
              Increase
              (Decrease)Net
      Sales
            
            $
            275
            
            
            $
            157
            
            
            $
            118
            
            
            
            75
            %Segment
      Profit
            
            $
            39
            
            
            $
            20
            
            
            $
            19
            
            
            
            95
            %Charges
      included in Segment Profit
            
            $
            (19
            )
            
            $
            (2
            )





The
increase in net sales as compared to the second quarter 2007 resulted primarily
from the Flexsys Acquisition.  Prior to May 1, 2007, the results of
Flexsys were accounted for using the equity method and were not recorded within
the Technical Specialties reportable segment.  The Flexsys Acquisition
resulted in an increase in net sales of $78 million or 50 percent. The
remaining increase in net sales was a result of higher average selling prices of
$19 million or 12 percent, higher sales volumes of $13 million or 8 percent and
favorable currency exchange rate fluctuations of $8 million or 5
percent.  Higher sales volumes and average selling prices were
experienced primarily in CRYSTEX® insoluble sulphur, SANTOFLEX® antidegradants
and THERMINOL® heat transfer
fluids.  The higher sales volumes were experienced predominantly in
targeted growth markets in Asia Pacific and Europe with modest increases in
North America.  The favorable exchange rate fluctuations occurred
primarily as a result of the weakening U.S. dollar in relation to the Euro in
comparison to the second quarter 2007.





The
increase in segment profit in comparison to the second quarter 2007 resulted
primarily from the Flexsys Acquisition, increased net sales as described above
and improved manufacturing performance, partially offset by the higher charges
and increased raw material costs.  The higher charges include a $13
million charge in the second quarter 2008 associated with the amortization of
the step-up in basis of our inventory in accordance with fresh-start
accounting.  The increased selling prices more than offset the
increase in raw material costs of approximately $15 million, which was
predominantly related to sulphur.  Improved manufacturing performance
was a result of higher asset utilization due to the increased volumes in this
segment.  In addition to the inventory step-up, segment profit
included charges related to the announced closure of the Ruabon Facility, which
resulted in charges of $6 million.  Segment profit in the second
quarter 2007 was negatively impacted by $2 million of charges resulting from the
step-up in basis of Flexsys’ inventory related to the acquisition.





34


Integrated
Nylon





Successor
            
            
            Predecessor(dollars
      in millions)
            
            Three
      Months
              Ended
              June
      30,
              2008
            
            
            Three
      Months
              Ended
              June
      30,
              2007
            
            
            Increase
              (Decrease)
            
            
            %
              Increase
              (Decrease)Net
      Sales
            
            $
            518
            
            
            $
            489
            
            
            $
            29
            
            
            
            6
            %Segment
      Profit (Loss)
            
            $
            (1
            )
            
            $
            38
            
            
            $
            (39
            )
            
            N.M.Gains
      (Charges) included in Segment Profit (Loss)
            
            $
            (5
            )
            
            $
            7





The
increase in net sales as compared to the second quarter 2007 resulted primarily
from higher average selling prices of $51 million or 10 percent, favorable
currency exchange rate fluctuations of $4 million or 1 percent, partially offset
by lower sales volumes of $26 million or 5 percent. In response to the
escalating cost of raw materials, average selling prices increased significantly
in the majority of the intermediate chemicals, carpet fibers and, to a lesser
extent, the nylon plastics and polymers businesses.  Sales volumes
decreased primarily in intermediate chemicals and carpet fibers, partially
offset by increases in nylon plastics and polymers.  The decrease in
carpet fibers is primarily due to weaknesses in the domestic housing market and
intermediate chemicals is due to lower global demand.  The increase in
nylon plastics and polymers volume of 28 percent was a result of additional
capacity brought on-stream late in the first quarter 2008 and continued growth
in global demand for these products.





The
decrease in segment results in comparison to the second quarter 2007 resulted
primarily from higher raw material costs of approximately $80 million, higher
charges, higher logistics costs and lower asset utilization, partially offset by
increased net sales as described above. The raw material cost profile of
Integrated Nylon was primarily impacted during the second quarter 2008 by
increases in propylene, ammonia and natural gas, key feedstocks for the
segment.  Higher logistics costs are related to increased volumes
shipped and higher fuel surcharges.  In addition, segment loss in the
second quarter 2008 was negatively impacted by a charge of $5 million resulting
primarily from the step-up in basis of our inventory in accordance with
fresh-start accounting.  Segment profit in the second quarter 2007
benefited from a $7 million gain resulting from a surplus land
sale.




The
segment has and will continue to increase selling prices in response to raw
material movements, although it does experience a lag in the selling price
movements versus raw material movements.  Currently, over 40 percent
of the segment’s pricing is formula based, which generally re-price
quarterly.   This lag had a negative impact on second quarter
results given the continued escalation of costs during the quarter, as the
segment was able to recover $51 million or approximately 64 percent of the
increased costs within the quarter.





Unallocated
and Other





Successor
            
            
            Predecessor(dollars
      in millions)
            
            Three
      Months
              Ended
              June
      30,
              2008
            
            
            Three
      Months
              Ended
              June
      30,
              2007
            
            
            Increase
              (Decrease)
            
            %
              Increase
              (Decrease)Unallocated
      and Other results
            
            $
            (6
            )
            
            $
            1
            
            
            $
            (7
            )
            N.M.Net
      gains included in Unallocated and Other
            
            $
            6
            
            
            $
            21





Unallocated
and Other results decreased due to lower net gains, lower interest income, lower
equity earnings from affiliates and higher corporate expenses, partially offset
by lower adjustments to our LIFO valuation reserve and higher segment profit
from other operations.  With respect to net gains in the second
quarter 2008, we recognized (i) a $3 million gain resulting from a surplus land
sale; (ii) a $4 million gain resulted from the settlement of emergence related
incentive accruals; and (iii) a $1 million charge resulting from the step-up in
basis of our inventory in accordance with fresh-start accounting.  In
the second quarter 2007, we reached a settlement on a litigation matter
resulting in a gain of $21 million.  Corporate expenses increased $3
million primarily due to share-based compensation expense on management
incentive and director stock compensation plans adopted upon our emergence from
bankruptcy and higher legal costs.  Share-based compensation expense
in 2007 was zero.  Adjustments to our LIFO valuation reserve were zero
in the second quarter 2008, compared to $16 million in the prior period, and are
expected to remain at zero throughout the year as our historical valuation
reserve was eliminated in accordance with the adoption of fresh-start accounting
and our base year valuation will be re-established by our end of year inventory
profile and costs.  The decrease in equity earnings from affiliates of
$3 million is a result of the Flexsys Acquisition completed on May 1,
2007.  Other income, net decreased by $1 million due to lower interest
income.


35





Interest
Expense





Successor
            
            
            Predecessor(dollars
      in millions)
            
            Three
      Months
              Ended
              June
      30,
              2008
            
            
            Three
      Months
              Ended
              June
      30,
              2007
            
            
            Increase
              (Decrease)
            
            
            %
              Increase
              (Decrease)Interest
      Expense
            
            $
            48
            
            
            $
            31
            
            
            $
            17
            
            
            
            55
            %





The
increase in interest expense in the second quarter 2008 in comparison to the
second quarter 2007 resulted principally from higher debt outstanding with
higher interest rates in the second quarter 2008 than in
2007.   Average debt not subject to compromise outstanding
increased $584 million or 47 percent, due to the emergence from Chapter 11
funding requirements.  The higher interest rates are a result of a
changed interest rate profile of our debt structure due to the replacement of
the debtor-in-possession ("DIP") credit facility with the Financing
Agreements.





Reorganization
Items, net





Successor
            
            
            Predecessor(dollars
      in millions)
            
            Three
      Months
                Ended
                June
      30,
                2008
            
            
            Three
      Months
                Ended
                June
      30,
                2007
            
            
            Increase
              (Decrease)
            
            %
              Increase
              (Decrease)Reorganization
      Items, net
            
            $
            --
            
            
            $
            (17
            )
            
            $
            17
            
            N.M.





Reorganization
items, net are presented separately in the Consolidated Statement of Operations
and represent items of income, expense, gain, or loss that are realized or
incurred by us because we were in reorganization under Chapter 11 of the U.S.
Bankruptcy Code.  We did not record any charges in reorganization
items in the second quarter 2008 due to our emergence from Chapter 11 on
February 28, 2008.





Income
Tax Expense





Successor
            
            
            Predecessor(dollars
      in millions)
            
            Three
      Months
                Ended
                June
      30,
                2008
            
            
            Three
      Months
              Ended
              June
      30,
              2007
            
            
            Increase
              (Decrease)
            
            %
              Increase
              (Decrease)Income
      Tax Expense
            
            $
            --
            
            
            $
            7
            
            
            $
            (7
            )
            N.M.





Our tax expense or benefit is affected
by the mix of income and losses in the tax jurisdictions in which we
operate. No income tax expense was recorded for the three months ended June
30, 2008 as income tax expense of $15 million, primarily attributable to
earnings in ex-U.S. tax jurisdictions, was offset by deferred income tax benefit
of an equal amount related to the amortization of an ex-U.S. fresh start
inventory revaluation.  Our U.S. operations experienced a pre-tax loss
in the second quarter 2008 but no income tax benefit was recognized during the
quarter as a full valuation allowance has been provided against the U.S.
deferred tax assets.





We
recorded income tax expense for the three months ended June 30, 2007 of $7
million on earnings in ex-U.S. tax jurisdictions combined with an increase in
unrecognized tax benefits.





Upon
emergence from bankruptcy, Successor has an estimated U.S. tax net operating
loss carryforward (“NOL”) of approximately $1.2 billion as of March 1,
2008.  As a result of the issuance of new common stock upon emergence,
we realized a change of ownership for purposes of Section 382 of the Internal
Revenue Code.  We do not currently expect this change to significantly
limit our ability to utilize our NOL in the carryforward period and do not
expect to be in a cash tax paying position in relation to U.S. taxes for the
foreseeable future.





36





Discontinued
Operations





Successor
            
            
            Predecessor(dollars
      in millions)
            
            Three
      Months
                  Ended
                  June
      30,
                  2008
            
            
            Three
      Months
                Ended
                June
      30,
                2007
            
            
            Increase
              (Decrease)
            
            %
              Increase
              (Decrease)Income
      from Discontinued Operations, net of tax
            
            $
            --
            
            
            $
            29
            
            
            $
            (29
            )
            N.M.





Income from discontinued operations
consists of the results of our Dequest business.  As described in Note
4 to the accompanying consolidated financial statements, on May 31, 2007, we
sold Dequest to Thermphos.  Included in the results of discontinued
operations in the second quarter 2007 is a gain on sale of the Dequest business
of $34 million, partially offset by income taxes of $5 million.





Combined
Results of Operations—Six Months Ended June 30, 2008 Compared with Six Months
Ended June 30, 2007





Consolidated
Results





Combined
            
            
            Predecessor(dollars
      in millions)
            
            Six
      Months Ended
              June
      30,
              2008
            
            
            Six
      Months
              Ended
              June
      30,
              2007
            
            
            Increase
              (Decrease)
            
            
            %
              Increase
              (Decrease)Net
      Sales
            
            $
            2,080
            
            
            $
            1,613
            
            
            $
            467
            
            
            
            29
            %Operating
      Income:Reportable
      Segment Profit
            
            $
            148
            
            
            $
            189
            
            
            $
            (41
            )
            
            
            (22
            %)Unallocated
      and Other
            
            
            (17
            )
            
            
            (11
            )
            
            
            (6
            )
            
            
            (55
            %)Less:   Depreciation
      and Amortization
            
            
            (67
            )
            
            
            (53
            )Less:   Equity
      Earnings from Affiliates, Other Income and Loss on Debt Modification
      included in Segment Profit (Loss) and Unallocated and
Other
            
            
            (8
            )
            
            
            (34
            )Operating
      Income
            
            $
            56
            
            
            $
            91
            
            
            $
            (35
            )
            
            
            (38
            %)Gains
      (Charges) included in Operating Income
            
            $
            (75
            )
            
            $
            4





The
increase in net sales as compared to the six months ended June 30, 2007 resulted
from the Flexsys Acquisition, higher sales volumes, increased selling prices and
the effect of favorable exchange rate fluctuations.  Prior to May 1,
2007, the results of Flexsys were accounted for using the equity method and
recorded as Equity Earnings from Affiliates on the Consolidated Statement of
Operations.  Net sales increased $281 million or 17 percent in the six
months ended June 30, 2008 as a result of the Flexsys
Acquisition.  The remaining $186 million or 12 percent increase in net
sales was a result of higher average selling prices of $116 million or 7
percent, favorable currency exchange rate fluctuations of $46 million or 3
percent and higher sales volumes of $24 million or 2 percent. Higher
average selling prices were experienced across all reporting segments given the
generally favorable supply/demand profile in these markets, new product
introductions in certain of our growth segments and in response to an escalating
raw material profile.  The favorable currency benefit was driven most
notably by the continued strengthening of the Euro versus the U.S. dollar, in
comparison to the prior year.  Other currency movements against the
U.S. dollar also benefited our net sales, however, given the strong market
positions in Europe within SAFLEX® and Technical Specialties, movements in the
Euro versus the U.S. dollar had the most significant impact on our
revenues.  The higher sales volumes were experienced in our SAFLEX®,
Technical Specialties and CPFilms reporting segments, given the continued
growing global demand for these products.  However, the higher sales
volumes in the other segments were partially offset by lower sales volumes
experienced in Integrated Nylon.  Within Integrated Nylon, we
experienced increased volumes for nylon plastics and polymers which were more
than offset by volume declines in carpet fibers and intermediate
chemicals.





37


The
decrease in operating income as compared to the six months ended June 30, 2007
resulted from higher charges of $79 million.  Factors that improved
operating income over the prior year were the impact of the Flexsys Acquisition,
increased net sales and higher asset utilization in our SAFLEX® and Technical
Specialties reporting segments and lower LIFO expense. Offsetting these
factors were higher raw material and energy costs of approximately $175 million
and lower asset utilization rates in Integrated Nylon.  As indicated
in the preceding table, operating results were affected by various charges which
are described in greater detail within this section below.  The raw
material impacts were most impactful within the Integrated Nylon segment, with
the key increases experienced in propylene, ammonia and natural
gas.  The increases in these raw materials are primarily driven by
continued tight supply of these materials, as well as the substantial increases
in oil prices when compared with the prior year.  We have and will
continue to increase selling prices in response to these material movements,
although we do experience a lag in the selling price movements versus raw
material movements.  This lag had a negative impact on year to date
results due to the escalating profile of our raw materials in the first six
months, as we were able to recover approximately 66 percent of the increased
costs within the six months ended June 30, 2008.  The lower
utilization rates in Integrated Nylon were due to the timing of scheduled
maintenance related shutdowns at several locations in the six months ended June
30, 2008.





SAFLEX®





Combined
            
            
            Predecessor(dollars
      in millions)
            
            Six
      Months
              Ended
              June
      30,
              2008
            
            
            Six
      Months
              Ended
              June
      30,
              2007
            
            
            Increase
              (Decrease)
            
            
            %
              Increase
              (Decrease)Net
      Sales
            
            $
            413
            
            
            $
            358
            
            
            $
            55
            
            
            
            15
            %Segment
      Profit
            
            $
            39
            
            
            $
            59
            
            
            $
            (20
            )
            
            
            (34
            %)Charges
      included in Segment Profit
            
            $
            (37
            )
            
            $
            --





The
increase in net sales as compared to the same period in 2007 was a result of
higher sales volumes of $16 million or 4 percent, higher average selling prices
of $12 million or 3 percent and favorable currency exchange rate fluctuations of
$27 million or 8 percent.  The favorable exchange rate fluctuations
occurred primarily as a result of the weakening U.S. dollar in relation to the
Euro in comparison to the same period in 2007. Higher sales volumes were
experienced in targeted growth markets of Europe and Asia Pacific and sales
volumes into the domestic market were lower than the prior year.  The
increased sales in Asia Pacific were a result of the continued expanding demand
for laminated glass in that market, which was partially supported by our new
SAFLEX® plant in Suzhou, China which opened in the third quarter
2007.





The
decrease in segment profit in comparison to the same period in 2007 resulted
primarily from the $36 million charge in the six months ended June 30, 2008
associated with the amortization of the step-up in basis of our inventory in
accordance with fresh-start accounting.   Offsetting this charge
was overall improvement in segment profit due to increased net sales as
described above, improved asset utilization and lower manufacturing
costs.  In addition to the inventory step-up, segment profit included
a charge of $1 million for severance and retraining costs.  The
segment also experienced approximately $15 million of higher raw material costs
in comparison to the prior year, of which $12 million or 80 percent was
recovered through increased selling prices.  The remaining increase in
raw material costs was more than offset through improved manufacturing
performance and higher sales volumes.





38


CPFilms





Combined
            
            
            Predecessor(dollars
      in millions)
            
            Six
      Months
              Ended
              June
      30,
              2008
            
            
            Six
      Months
              Ended
              June
      30,
              2007
            
            
            Increase
              (Decrease)
            
            
            %
              Increase
              (Decrease)Net
      Sales
            
            $
            133
            
            
            $
            125
            
            
            $
            8
            
            
            
            6
            %Segment
      Profit
            
            $
            28
            
            
            $
            36
            
            
            $
            (8
            )
            
            
            (22
            %)Charges
      included in Segment Profit
            
            $
            (10
            )
            
            $
            --





The
increase in net sales as compared to the six months ended June 30, 2007 resulted
primarily from higher sales volumes of $4 million or 3 percent and higher
average selling prices of $3 million or 2 percent and favorable currency
exchange rate fluctuations of $1 million or 1 percent.  The increase
in sales volumes primarily resulted from strong growth in CPFilms’ international
window film markets, most notably Russia, South Africa and the Middle East, and
continued growth of the industrial business, partially offset by overall lower
demand in North America in the six months ended June 30, 2008 due to the
challenging macro-economic conditions specific to this market.





The
decrease in segment results in comparison to the same period in 2007 resulted
primarily from the $10 million charge in the six months ended June 30, 2008
associated with the amortization of the step-up in basis of our inventory in
accordance with fresh-start accounting.  Partially offsetting the
inventory step-up, and despite weaker volumes in the domestic markets, was
higher gross profit in comparison to the prior year, which was partially offset
by increased investment in sales and marketing infrastructure and in market
development programs globally.  We believe continued investment in the
sales and marketing infrastructure for this segment will expand the overall
global window film market along with our participation.





Technical
Specialties


Combined
            
            
            Predecessor(dollars
      in millions)
            
            Six
      Months
              Ended
              June
      30,
              2008
            
            
            Six
      Months
              Ended
              June
      30,
              2007
            
            
            Increase
              (Decrease)
            
            %
              Increase
              (Decrease)Net
      Sales
            
            $
            527
            
            
            $
            195
            
            
            $
            332
            
            N.M.Segment
      Profit
            
            $
            91
            
            
            $
            28
            
            
            $
            63
            
            N.M.Charges included in Segment Profit
            
            $
            (26
            )
            
            $
            (2
            )





The
increase in net sales as compared to the same period in 2007 resulted primarily
from the Flexsys Acquisition.  Prior to May 1, 2007, the results of
Flexsys were accounted for using the equity method and were not recorded within
the Technical Specialties reportable segment.  The Flexsys Acquisition
resulted in an increase in net sales of $281 million.  The remaining
increase in net sales was a result of higher sales volumes of $21 million or 11
percent, higher average selling prices of $21 million or 11 percent and
favorable currency exchange rate fluctuations of $9 million or 5
percent.  Higher sales volumes and average selling prices were
experienced primarily in CRYSTEX® insoluble sulphur, SANTOFLEX® antidegradants
and THERMINOL® heat
transfer fluids.  The higher sales volumes were experienced
predominantly in targeted growth markets in Asia Pacific and Europe with minor
increases in North America.  The favorable exchange rate fluctuations
occurred primarily as a result of the weakening U.S. dollar in relation to the
Euro in comparison to the same period in 2007.





39


The
increase in segment profit in comparison to the same period in 2007 resulted
primarily from the Flexsys Acquisition, increased net sales as described above
and improved manufacturing performance, partially offset by higher charges and
increased raw material costs.  The higher charges include a $20
million charge in the six months ended June 30, 2008 associated with the
amortization of the step-up in basis of our inventory in accordance with
fresh-start accounting.  The increased selling prices more than offset
the increase of $15 million in raw material costs primarily related to
sulphur.  Improved manufacturing performance was a result of higher
asset utilization due to the increased volumes in this segment.  In
addition to the inventory step-up, segment profit included charges related to
the announced closure of the Ruabon Facility, which resulted in charges of $6
million.  Segment profit in the comparable period in 2007 was
negatively impacted by $2 million of charges resulting from the step-up in basis
of Flexsys’ inventory related to the acquisition.





Integrated
Nylon





Combined
            
            
            Predecessor(dollars
      in millions)
            
            Six
      Months
              Ended
              June
      30,
              2008
            
            
            Six
      Months
              Ended
              June
      30,
              2007
            
            
            Increase
              (Decrease)
            
            
            %
              Increase
              (Decrease)Net
      Sales
            
            $
            986
            
            
            $
            916
            
            
            $
            70
            
            
            
            8
            %Segment
      Profit (Loss)
            
            $
            (10
            )
            
            $
            66
            
            
            $
            (76
            )
            
            N.M.Gains
      (Charges) included in Segment Profit (Loss)
            
            $
            (7
            )
            
            $
            7





The
increase in net sales as compared to the second quarter 2007 resulted primarily
from higher average selling prices of $81 million or 9 percent and favorable
currency exchange rate fluctuations of $7 million or 1 percent, partially offset
by lower sales volumes of $18 million or 2 percent.  In response to
the escalating cost of raw materials, average selling prices increased
significantly in the majority of the intermediate chemicals, carpet fibers and,
to a lesser extent, the nylon plastics and polymers businesses. Sales
volumes increased primarily in nylon plastics and polymers, partially offset by
decreases in carpet fibers primarily due to weaknesses in the domestic housing
market.  The increase in nylon plastics and polymers volume of 33
percent was a result of additional capacity brought on-stream late in the first
quarter 2008 and continued growth in global demand for these
products.





The
decrease in segment results in comparison to the same period in 2007 resulted
primarily from higher raw material costs of approximately $145 million, higher
manufacturing and logistic costs, higher charges and lower asset utilization,
partially offset by increased net sales as described above.  The raw
material cost profile of Integrated Nylon was primarily impacted during the six
months ended June 30, 2008 by increases in propylene, ammonia and natural gas,
key feedstocks for the segment.  Higher manufacturing costs and lower
asset utilization were a result of scheduled maintenance shutdowns in
intermediate chemicals at the Decatur, Alabama and Alvin, Texas plants and
carpet fibers at the Greenwood, South Carolina plant in the six months ended
June 30, 2008. Further, lower asset utilization was experienced in carpet
fibers at the Pensacola, Florida plant due to the aforementioned sales volume
decrease.  Higher logistics costs are related to increased volumes
shipped and higher fuel surcharges.  In addition, segment loss in 2008
was negatively impacted by a charge of $7 million resulting primarily from the
step-up in basis of our inventory in accordance with fresh-start
accounting.  Segment profit in 2007 benefited from a $7 million gain
resulting from a surplus land sale.





The
segment has and will continue to increase selling prices in response to raw
material movements, although it does experience a lag in the selling price
movements versus raw material movements.  Currently, over 40 percent
of the segment’s pricing is formula based, which generally re-price
quarterly.   This lag had a significant negative impact on year
to date results given the continued escalation of costs during the year, as the
segment was able to recover $81 million or approximately 56 percent of the
increased costs within the six months ended June 30, 2008.





40


Unallocated
and Other





Combined
            
            
            Predecessor(dollars
      in millions)
            
            Six
      Months
              Ended
              June
      30,
              2008
            
            
            Six
      Months
              Ended
              June
      30,
              2007
            
            
            Increase
              (Decrease)
            
            
            %
              Increase
              (Decrease)Unallocated
      and Other results
            
            $
            (17
            )
            
            $
            (11
            )
            
            $
            (6
            )
            
            
            (55
            %)Net
      gains included in Unallocated and Other
            
            $
            9
            
            
            $
            14





Unallocated
and Other results decreased due to lower net gains, lower interest income, lower
equity earnings from affiliates and higher corporate expenses, partially offset
by lower adjustments to our LIFO valuation reserve and higher segment profit
from other operations.  With respect to net gains, in the six months
ended June 30, 2008, we recorded (i) a gain of $3 million related to joint
settlements with Monsanto of legacy insurance policies with insolvent insurance
carriers; (ii) a gain of $3 million resulting from a surplus land sale; (iii) a
$4 million gain resulted from the settlement of emergence related incentive
accruals; and (iv) a $1 million charge resulting from the step-up in basis of
our inventory in accordance with fresh-start accounting.  In the same
period in 2007, we reached a settlement on a litigation matter resulting in a
gain of $21 million, partially offset by a charge of $7 million recorded to
write-off debt issuance costs and to record the DIP credit facility as modified
at its fair value as of the amendment date. Corporate expenses increased $3
million primarily due to share-based compensation expense on management
incentive and director stock compensation plans adopted upon our emergence from
bankruptcy and higher legal costs.  Share-based compensation expense
in 2007 was zero.  Adjustments to our LIFO valuation reserve were zero
for the six months ended June 30, 2008, compared to $20 million in the prior
period, and are expected to remain at zero throughout the year as our historical
valuation reserve was eliminated in accordance with the adoption of fresh-start
accounting and our base year valuation will be re-established by our end of year
inventory profile and costs.  The decrease in equity earnings from
affiliates of $12 million is a result of the Flexsys Acquisition completed on
May 1, 2007.  Other income, net decreased by $6 million due to lower
gains on foreign currency hedges and lower interest income.




Interest
Expense





Combined
            
            
            Predecessor(dollars
      in millions)
            
            Six
      Months
              Ended
              June
      30,
              2008
            
            
            Six
      Months
              Ended
              June
      30,
              2007
            
            
            Increase
              (Decrease)
            
            
            %
              Increase
              (Decrease)Interest
      Expense
            
            $
            87
            
            
            $
            59
            
            
            $
            28
            
            
            
            47
            %





The
increase in interest expense in the six months ended June 30, 2008 in comparison
to the same period in 2007 resulted principally from higher debt outstanding
with higher interest rates in 2008 than in 2007.   Average debt
outstanding increased $488 million or 45 percent to fund the Flexsys
Acquisition, as only a portion of debt utilized to acquire Flexsys was incurred
prior to the end of the first quarter of 2007, and our emergence from Chapter 11
on the Effective Date.  The higher interest rates are a result of a
changed interest rate profile of our debt structure due to the replacement of
the DIP credit facility with the Financing Agreements.





41


Reorganization
Items, net





Combined
            
            
            Predecessor(dollars
      in millions)
            
            Six
      Months
              Ended
              June
      30,
              2008
            
            
            Six
      Months
              Ended
              June
      30,
              2007
            
            
            Increase
              (Decrease)
            
            %
              Increase
              (Decrease)Reorganization
      Items, net
            
            $
            1,642
            
            
            $
            (33
            )
            
            $
            1,675
            
            N.M.





Reorganization
items, net are presented separately in the Consolidated Statement of Operations
and represent items of income, expense, gain, or loss that are realized or
incurred by us because we were in reorganization under Chapter 11 of the U.S.
Bankruptcy Code.  Reorganization items incurred in the six months
ended June 30, 2008 included a $104 million charge on the settlement of
liabilities subject to compromise, $1,798 million gain from fresh-start
accounting adjustments, and $52 million of professional fees for services
provided by debtor and creditor professionals directly related to our
reorganization proceedings.  The increase in reorganization items, net
as compared to the six months ended June 30, 2007 is due to the aforementioned
effects of settling the liabilities subject to compromise and adopting
fresh-start accounting.  In addition, professional fees increased $20
million due to the necessary support for our emergence from Chapter
11.





Income
Tax Expense





Combined
            
            
            Predecessor(dollars
      in millions)
            
            Six
      Months
              Ended
              June
      30,
              2008
            
            
            Six
      Months
              Ended
              June
      30,
              2007
            
            
            Increase
              (Decrease)
            
            %
              Increase
              (Decrease)Income
      Tax Expense
            
            $
            215
            
            
            $
            14
            
            
            $
            201
            
            N.M.





Our tax expense or benefit is affected
by the mix of income and losses in the tax jurisdictions in which we
operate. The income tax expense recorded for the six months ended June 30,
2008 was primarily attributable to emergence and the effect of adopting
fresh-start accounting, which accounted for $203 million of the
total.  The remaining $12 million of income tax expense for the six
months ended June 30, 2008 was related to earnings in ex-U.S. tax
jurisdictions.





We
recorded income tax expense for the six months ended June 30, 2007 of $14
million, entirely attributable to earnings in ex-U.S. tax jurisdictions combined
with an increase in unrecognized tax benefits.





The
change in income tax expense for the six months ended June 30, 2008 compared to
the six months ended June 30, 2007 was primarily the result of the
emergence in the six months ended June 30, 2008.





Upon
emergence from bankruptcy, Successor has an estimated NOL of approximately $1.2
billion as of March 1, 2008.  As a result of the issuance of new
common stock upon emergence from bankruptcy, we realized a change of ownership
for purposes of Section 382 of the Internal Revenue Code.  We do not
currently expect this change to significantly limit our ability to utilize our
NOL in the carryforward period and do not expect to be in a cash paying tax
position in relation to U.S. taxes for the foreseeable future.





42


Discontinued
Operations





Combined
            
            
            Predecessor(dollars
      in millions)
            
            Six
      Months
                Ended
                June
      30,
                2008
            
            
            Six
      Months
              Ended
              June
      30,
              2007
            
            
            Increase
              (Decrease)
            
            %
              Increase
              (Decrease)Income
      from Discontinued Operations, net of tax
            
            $
            --
            
            
            $
            29
            
            
            $
            (29
            )
            N.M.





Income from discontinued operations
consists of the results of our Dequest business.  As described in Note
4 to the accompanying consolidated financial statements, on May 31, 2007, we
sold Dequest to Thermphos.  Included in the results of discontinued
operations in the six months ended June 30, 2007 is a gain on sale of the
Dequest business of $34 million, partially offset by income taxes of $5
million.





Summary
of Events Affecting Comparability





Charges
and gains recorded in the six months ended June 30, 2008 and 2007 and other
events affecting comparability have been summarized and described in the table
and accompanying footnotes below (dollars in millions):




2008
Events


Increase/(Decrease)
            
            SAFLEX®
            
            
            CPFilms
            
            
            Technical
      Specialties
            
            
            Integrated
      Nylon
            
            
            Unallocated
              /Other
            
            
            ConsolidatedImpact
      on:Cost
      of goods sold
            
            $
            36
            
            
            $
            10
            
            
            $
            20
            
            
            $
            7
            
            
            $
            1
            
            
            $
            74
            
            (a)--
            
            
            
            --
            
            
            
            6
            
            
            
            --
            
            
            
            --
            
            
            
            6
            
            (b)--
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            (3
            )
            
            
            (3
            )
            (c)1
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            1
            
            (d)Research,
      development and other operating expenses
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            (3
            )
            
            
            (3
            )
            (e)Operating
      Income Impact
            
            
            (37
            )
            
            
            (10
            )
            
            
            (26
            )
            
            
            (7
            )
            
            
            5
            
            
            
            (75
            )Other
      income, net
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            4
            
            
            
            4
            
            (f)Reorganization
      Items, net
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            1,642
            
            
            
            1,642
            
            (g)Pre-tax
      Income Statement Impact
            
            $
            (37
            )
            
            $
            (10
            )
            
            $
            (26
            )
            
            $
            (7
            )
            
            $
            1,651
            
            
            
            1,571Income
      tax impact
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            188
            
            (h)After-tax
      Income Statement Impact
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            1,383




(a)
              Charges
      resulting from the step-up in basis of our inventory in accordance with
      fresh-start accounting ($74 million pre-tax and $59 million
      after-tax).(b)
              Charges
      related to the announced closure of the Ruabon Facility ($5 million
      pre-tax and after-tax).(c)
              Gain
      resulting from settlements of legacy insurance policies with insolvent
      insurance carriers ($3 million pre-tax and after-tax).(d)
              Restructuring
      costs related principally to severance and retraining costs ($2 million
      pre-tax and after-tax).(e)
              Gain
      resulting from a surplus land sale ($3 million pre-tax and
      after-tax).(f)
              Gain
      resulting from the settlement of emergence related incentive accruals ($4
      million pre-tax and after-tax).(g)
              Reorganization
      items, net consist of the following:  $104 million charge on the
      settlement of liabilities subject to compromise, $1,798 million gain from
      fresh-start accounting adjustments, and $52 million of professional fees
      for services provided by debtor and creditor professionals directly
      related to our reorganization proceedings ($1,642 million pre-tax and
      $1,439 million after-tax).(h)
              Income
      tax expense has been provided on gains and charges at the tax rate in the
      jurisdiction in which they have been or will be
  realized.


43




2007
Events


Increase/(Decrease)
            
            SAFLEX®
            
            
            CPFilms
            
            
            Technical
              Specialties
            
            
            Integrated
      Nylon
            
            
            Unallocated
              /Other
            
            
            ConsolidatedImpact
      on:Cost
      of goods sold
            
            $
            --
            
            
            $
            --
            
            
            $
            2
            
            
            $
            --
            
            
            $
            --
            
            
            $
            2
            
            (a)Research,
      development and other operating expenses
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            (7
            )
            
            
            --
            
            
            
            (7
            )
            (b)Operating
      Income Impact
            
            
            --
            
            
            
            --
            
            
            
            (2
            )
            
            
            7
            
            
            
            --
            
            
            
            5Other
      income, net
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            21
            
            
            
            21
            
            (c)Loss
      on debt modification
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            (7
            )
            
            
            (7
            )
            (d)Reorganization
      Items, net
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            (33
            )
            
            
            (33
            )
            (e)Pre-tax
      Income Statement Impact
            
            $
            --
            
            
            $
            --
            
            
            $
            (2
            )
            
            $
            7
            
            
            $
            (19
            )
            
            
            (14
            )Income
      tax impact
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (1
            )
            (f)After-tax
      Income Statement Impact
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            (13
            )




(a)
              Charge
      resulting from the step-up in basis of Flexsys’ inventory in accordance
      with purchase accounting in the second quarter ($2 million pre-tax and $1
      million after-tax).(b)
              Gain
      resulting from a surplus land sale ($7 million pre-tax and after-tax – see
      note (f) below).(c)
              Settlement
      gain, net of legal expenses in the second quarter ($21 million pre-tax and
      after-tax – see note (f) below).(d)
              We
      recorded a charge of approximately $7 million (pre-tax and after-tax – see
      note (f) below) in the first quarter to record the write-off of debt
      issuance costs and to record the DIP facility
  modification.(e)
              Reorganization
      items, net consist of the following:  $32 million of
      professional fees for services provided by debtor and creditor
      professionals directly related to our reorganization proceedings; $3
      million of expense provisions related to (i) employee severance costs
      incurred directly as part of the Chapter 11 reorganization process and
      (ii) a retention plan for certain of our employees approved by the
      Bankruptcy Court; offset by a $2 million gain realized from a claim
      settlement ($33 million pre-tax and after-tax – see note (f)
      below).(f)
              With
      the exception of item (a) above, which related to operations not in
      reorganization, the above items were considered to have like pre-tax and
      after-tax impact as the tax benefit or expense realized from these events
      is offset by the change in valuation allowance for U.S. deferred tax
      assets resulting from uncertainty as to their recovery due to our Chapter
      11 bankruptcy filing.





Financial
Condition and Liquidity




On the
Effective Date, we entered into Financing Agreements to borrow up to $2.05
billion from the Lenders.  The proceeds from the Financing Agreements
were used to (i) repay the DIP credit facility, (ii) retire Solutia Services
International S.C.A./Comm. V.A.’s (“SSI”) Facility Agreement due 2011, (iii)
retire the Flexsys term loan and revolving credit facility due 2012, (iv) pay
certain secured and administrative claims, and (v) provide additional liquidity
for operations.  The Financing Agreements consist of (i) a $450
million senior secured asset-based revolving credit facility which is comprised
of a U.S Facility and a Belgium Facility (“Revolver”), (ii) a $1.2 billion
senior secured term loan facility (“Term Loan”) and (iii) a $400 million senior
unsecured bridge facility (“Bridge”).  A further description of the
Financing Agreements and copies thereof are contained in our Current Report on
Form 8-K filed with the SEC on March 4, 2008.





In the
second quarter of 2008, our Form S-3 shelf registration statement with the
SEC became effective which allows us at any time and from time to time, in one
or more offerings, to sell the debt and equity securities described therein of
up to $600 million.  We expect to use the net proceeds from the sale
of our debt and equity securities for the repayment of indebtedness, to finance
acquisitions or for general corporate and working capital purposes. We may
invest the net proceeds temporarily or apply them to repay short-term or
revolving debt until we use them for their stated purpose.





44


Cash
Flow





Combined
            
            
            Predecessor(dollars
      in millions)
            
            Six
      Months
              Ended
              June
      30,
              2008
            
            
            Six Months
              Ended
              June
      30,
              2007
            
            
            Increase
              (Decrease)Continuing
      OperationsCash
      used in operating activities
            
            $
            (438
            )
            
            $
            (114
            )
            
            $
            (324
            )Cash
      used in investing activities
            
            
            (28
            )
            
            
            (180
            )
            
            
            152Cash
      provided by financing activities
            
            
            339
            
            
            
            304
            
            
            
            35





The
increased usage of cash from operating activities compared to the six months
ended June 30, 2007 is primarily related to payments for our emergence from
Chapter 11 during 2008 of $375 million along with a seasonal build up in working
capital, partially offset by lower contributions to the domestic pension
plan.  Included in the $375 million of usage related to emergence is
$221 million of proceeds from the rights offering that is classified as
restricted cash or plan assets of our domestic other postretirement plans in the
current period.  These funds will be used to fund certain future other
postretirement benefits payments, environmental remediation activities and other
legacy related payments.





The lower
usage of cash from investing activities in the six months ended June 30, 2008 as
compared to the same period in 2007 is due to the Flexsys Acquisition in 2007
for $115 million, in contrast to the cash generated by the sale of our corporate
headquarters building in 2008 for $43 million.





The
increase in cash provided by financing activities in the six months ended June
30, 2008 is primarily the result of cash received of $2.05 billion from the
Financing Agreements and the Creditor Rights Offering, partially offset by
payments of $1.72 billion to (i) repay the DIP credit facility, (ii) retire
SSI’s Facility Agreement due 2011, (iii) retire the Flexsys term loan and
revolving credit facility due 2012, (iv) pay certain secured and administrative
claims, (v) retire the debt related to our corporate headquarters building, and
(vi) provide additional liquidity for operations.  The cash provided
by financing activities in the six months ended June 30, 2007 resulted primarily
from $325 million of additional borrowings from our DIP credit facility and $41
million of net borrowings under the Flexsys term loan and revolving credit
facility, partially offset by a pay down of $53 million to the DIP credit
facility from the proceeds of the Dequest sale.





Working
Capital





Successor
            
            
            Predecessor(dollars
      in millions)
            
            June
      30,
              2008
            
            
            December
      31,
              2007
            
            Increase
              (Decrease)Continuing
      OperationsCurrent
      assets
            
            $
            1,588
            
            
            $
            1,224Current
      liabilities
            
            
            758
            
            
            
            1,621Working
      Capital
            
            $
            830
            
            
            $
            (397
            )
            $1,227





Our
working capital increased primarily as a result of the payoff of our DIP credit
facility on the Effective Date, the elimination of the LIFO reserve in
accordance with fresh-start accounting and seasonal increases in working
capital, partially offset by a decrease in cash to fund our emergence from
Chapter 11.  In addition to seasonality, inventories and accounts
payable each increased due to higher raw material costs and the effects of the
weaker U.S. dollar versus relevant currencies.  Accounts receivable
increased in conjunction with us consistently raising prices in reaction to a
rising raw material trend along with a similar affect attributable to a weaker
U.S. dollar.





45


Debt
and Liquidity





Total
debt of $1,803 million as of June 30, 2008 decreased by $197 million as
compared to $2,000 million at December 31, 2007, including $659 million subject
to compromise and $1,341 million not subject to compromise.  This
decrease in total debt resulted from the settlement of debt subject to
compromise through stock and cash settlements and the retirement of all debt
facilities not subject to compromise at December 31, 2007.  The
payments were funded by the Financing Agreements and the sale of our corporate
headquarters building in the second quarter 2008 for $43 million.





The
weighted average interest rate on our total debt outstanding was approximately
9.6 percent and 7.9 percent at June 30, 2008 and December 31, 2007,
respectively.  The increase is due to higher interest rates on the
Financing Agreements to fund our emergence from Chapter 11.





At June
30, 2008, our total liquidity was $242 million in the form of $195 million of
availability under the Revolver and $47 million of cash on-hand.  In
comparison, our total liquidity at December 31, 2007 was $428 million in the
form of $152 million of availability under the DIP credit facility, $103 million
of availability under the Flexsys Debt Facility and $173 million of cash
on-hand.   Based upon current and anticipated levels of
operations during the fiscal year, we believe that our liquidity and capital
resources will be sufficient to maintain our normal operations at current
levels.




Pension
Funding





According
to current IRS funding rules, we will be required to make approximately $54
million in pension contributions to our U.S. qualified pension plan in
2008.  Approximately $26 million of these required 2008 contributions
were made in the six months ended June 30, 2008.  We also expect to be
required to fund approximately $5 million in pension contributions to our
foreign pension plans in 2008.





Contingencies





See Note
10 to the accompanying consolidated financial statements for a summary of our
contingencies as of June 30, 2008.





Item
3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
FACTORS





There
have been no material changes in market risk exposures during the six months
ended June 30, 2008 that affect the disclosures presented in the information
appearing under “Derivative Financial Instruments” as presented in our Form
10-K, as re-casted and filed with the SEC in a form 8-K on July 25, 2008, to
reflect our segment reporting change as described in Note 13 to the accompanying
consolidated financial statements.





Item
4.  CONTROLS AND PROCEDURES





During
the period covered by this Form 10-Q, we carried out an evaluation, under the
supervision and with the participation of our management, including our Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of our disclosure controls and procedures (as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934
(“Exchange Act”)).  Based upon that evaluation, the Chief Executive
Officer and Chief Financial Officer concluded that, as of the end of the period
covered by this Form 10-Q, our disclosure controls and procedures are effective
in timely alerting them to material information relating to us and our
consolidated subsidiaries that is required to be included in our periodic SEC
filings.  The Chief Executive Officer and Chief Financial Officer also
concluded that, as of the end of the period covered by this Form 10-Q, our
disclosure controls and procedures are effective to provide reasonable assurance
that we record, process, summarize, and report the required disclosure
information within the specified time periods.  Further, there were no
changes in our internal control over financial reporting (as defined in Rules
13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the
quarterly period ended June 30, 2008 that have materially affected, or are
reasonably likely to materially affect our internal controls over financial
reporting.





46





PART
II.  OTHER INFORMATION








ITEM
1.  LEGAL PROCEEDINGS





Legal Proceedings Resolved
in Our Chapter 11 Process





Certain
adversary proceedings and claim objections, as summarized in our 2007 Form 10-K
as Citigroup Global Markets,
et al. Adversary Proceeding,JPMorgan Adversary
Proceeding,Equity
Committee Adversary Proceeding Against Monsanto and Pharmacia,and Dispute Regarding Proof of Claim of Bank
of New York, were resolved as part of our emergence from Chapter 11
through the distributions made under the Plan, or with the establishment of a
disputed claim reserve from which future New Common Stock distributions will be
made. Further, with respect to the matter captioned as Savings and Investment Plan
Litigationin the 2007 Form 10-K,in December 2007, the
parties to the Savings and Investment Plan bankruptcy claim and litigation
reached a global settlement of all outstanding issues and subsequently entered
into a formal settlement agreement to that effect.  The amount of the
settlement to be paid in New Common Stock is less than the $15 million disputed
claims reserve established for such matter.  The United States
District Court, Southern District of New York has tentatively approved the
settlement and has scheduled a fairness hearing for September 17, 2008 for final
confirmation. In connection with the settlement, the Department of Labor has
provided notice it will take no further action arising out of its investigation
of the Savings and Investment Plan (captioned in the 2007 Form 10-K as Department of Labor Investigation of
Solutia Inc. Savings and Investment Plan), pending final confirmation of
the settlement.





Legal Proceedings Ongoing
Post-Chapter 11





The
following is a summary of legal proceedings in which there have been
developments since our last periodic filing and which, if resolved unfavorably,
could have a material adverse effect on our consolidated liquidity and
profitability.  Certain of these matters relate to Flexsys, which
became a 100% owned subsidiary on May 1, 2007 upon our acquisition of the 50%
interest owned by Akzo Nobel.  All
claims in these litigation matters regard alleged conduct occurring while
Flexsys was a joint venture of Solutia and Akzo Nobel, and any potential damages
in these cases would be evenly apportioned between Solutia and Akzo
Nobel.


Flexsys
Patent and Related Litigation





Flexsys
holds various patents covering inventions in the manufacture of rubber
chemicals, including patents describing and claiming a manufacturing process for
4-aminodiphenylamine ("4-ADPA"), a key building block for the manufacture of
6PPD and IPPD, as well as a manufacturing process for 6PPD and IPPD, which
function as anti-degradants and are used primarily in the manufacture of rubber
tires.  Flexsys is engaged in litigation in several jurisdictions to
protect and enforce its patents.





Legal
Proceedings in the United States





The ITC-1
proceeding.  In February 2005, Flexsys filed a complaint with
the U.S. International Trade Commission ("ITC"), requesting that the ITC
initiate an investigation against Sinorgchem Co. Shangdong, a Chinese entity
("Sinorgchem"), Korea Kumho Petrochemical Company, a Korean company ("KKPC"),
and third party distributors of Sinorgchem.  Flexsys claims that the
process Sinorgchem uses to make 4-ADPA and 6PPD, its sale of 6PPD for
importation into the United States, and Sinorgchem's sale of 4-ADPA to KKPC and
KKPC's importation of 6PPD into the United States are covered by Flexsys’
patents.  Accordingly, Flexsys requested that the ITC issue a limited
exclusion order prohibiting the importation into the United States of 4-ADPA and
6PPD originating from these entities.  In February 2006, an
Administrative Law Judge ("ALJ") of the ITC determined that Flexsys’ patents
were valid, that the process used by Sinorgchem to make 4-ADPA and 6PPD was
covered by Flexsys’ patents, and that Sinorgchem and its distributor, but not
KKPC, had violated section 1337 of the U.S. Tariff Act.  In July 2006,
the ITC substantially upheld the ALJ's decision on the basis of literal
infringement, and subsequently issued a limited exclusion order against
Sinorgchem and its distributor prohibiting them from importing 4-ADPA and 6PPD
manufactured by Sinorgchem into the United States.





Sinorgchem
appealed the ITC decision to the United States Court of Appeals for the Federal
Circuit. On December 21, 2007, a three-judge panel of the Federal Circuit
overruled the ITC’s finding that Sinorgchem had literally infringed Flexsys’
patent and remanded the matter to the ITC to determine whether Sinorgchem’s
processes infringe Flexsys’ patent on other grounds set forth by
Flexsys.  The limited exclusion order was lifted, and the matter is
currently before the ALJ for consideration of the infringement claim on these
other grounds.





47


The ITC-2
proceeding.  In May 2008, Flexsys filed a second complaint with
the ITC, requesting that the ITC initiate an investigation against Sinorgchem,
KKPC, Kumho Tire Co. Inc., and Kumho Tire USA, Inc.  Flexsys’
complaint requests that the ITC issue a limited exclusion order prohibiting the
importation into the United States of 4-ADPA and 6PPD originating from these
entities. The May 2008 ITC complaint alleges that Sinorgchem violated Flexsys’
patents for producing intermediate materials used to make 4-ADPA.  The
ITC formally instituted an investigation pursuant to this complaint on July 3,
2008.





In re Rubber
Chemicals Antitrust Litigation.  In April 2006, KKPC filed suit
against Flexsys in the United States District Court for the Central District of
California for alleged violations of the Sherman Act, breach of contract, breach
of the implied covenant of good faith and fair dealing, declaratory relief,
intentional interference with prospective economic advantage, disparagement and
violations of the California Business & Professions Code.  This
matter was subsequently transferred to the United States District Court,
Northern District of California.  The court dismissed KKPC’s initial
complaint, but granted KKPC the right to refile an amended complaint, which KKPC
filed in September 2007.  Flexsys filed a motion to dismiss the
amended complaint, which was granted in part, and denied in
part.  Specifically, the court dismissed all pending antitrust claims
against Flexsys, but did not dismiss two state law claims for unfair competition
and tortious interference.  The court granted KKPC the right to refile
another amended complaint, which KKPC filed in April 2008.  Flexsys
moved to dismiss the latest amended complaint and the motion is
pending.





Legacy
Tort Litigation





Pursuant
to the Monsanto Settlement Agreement, Monsanto is responsible to defend and
indemnify Solutia for any Legacy Tort Claims as that term is defined in the
agreement, while Solutia retains responsibility for tort claims arising out of
exposure occurring after the Solutia Spin-off.  Solutia has been named
as a defendant in the following action and has tendered the matter to Monsanto
as a Legacy Tort Claim.  Solutia would potentially be liable with respect
to such matter to the extent it relates to post Solutia Spinoff exposure or such
matter is not within the meaning of "Legacy Tort Claims" within the Monsanto
Settlement Agreement.





Escambia County, Florida Litigation.On June 6, 2008, a group of approximately 50 property owners and business
owners in the Pensacola, Florida area filed a lawsuit in the Circuit Court for
Escambia County, Florida against Monsanto, Pharmacia, Solutia, and the plant
manager at Solutia's Pensacola plant.  The lawsuit, entitled John Allen, et al. v. Monsanto
Company, et al., alleges that the defendants are responsible for elevated
levels of PCBs in the Escambia River and Escambia Bay due to past and allegedly
continuing releases of PCBs from the Pensacola plant.  The plaintiffs
seek: (1) damages associated with alleged decreased property values caused
by the alleged contamination, and (2) remediation of the alleged
contamination in the waterways.





Cash
Balance Plan Litigation





Since
October 2005, current and former participants in the Solutia Inc. Employees’
Pension Plan (the “Pension Plan”) have filed three class actions alleging that
the Pension Plan is discriminatory based upon age and that the lump sum values
of individual account balances in the Pension Plan have been, and continue to
be, miscalculated.  Solutia has not been named as a defendant in any
of these cases.  Two of these cases, captioned Davis, et al. v. Solutia, Inc.
Employees’ Pension Plan and Hammond, et al. v. Solutia, Inc.
Employees’ Pension Plan, are still pending in the Southern District of
Illinois, and have been consolidated with similar cases against Monsanto Company
and the Monsanto Company Pension Plan (Walker et al. v. The Monsanto
Pension Plan, et al.) and the Pharmacia Cash Balance Pension Plan,
Pharmacia Corporation, Pharmacia and Upjohn, Inc., and Pfizer Inc. (Donaldson v. Pharmacia Cash Balance
Pension Plan, et al.).  The plaintiffs in the Pension Plan
cases seek to obtain injunctive and other equitable relief (including money
damages awarded by the creation of a common fund) on behalf of themselves and
the nationwide putative class of similarly situated current and former
participants in the Pension Plan.





A
Consolidated Class Action Complaint (the “Complaint”) was filed by all of the
plaintiffs in the consolidated case on September 4, 2006.  The
Complaint alleged three separate causes of action against the Pension Plan: (1)
the Pension Plan violates the Employee Retirement Income Security Act (“ERISA”)
by terminating interest credits on prior plan accounts at the age of 55; (2) the
Pension Plan is improperly backloaded in violation of ERISA; and (3) the Pension
Plan is discriminatory on the basis of age.  In September 2007, the
second and third of these claims were dismissed by the court.





By
consent of the parties, the court certified a class with respect to the Pension
Plan on plaintiffs’ claim that the Pension Plan discriminated against employees
on the basis of their age by only providing interest credits on prior plan
accounts through age 55.  Summary judgment motions were filed in the
case on July 11, 2008, and are currently pending.  A trial, if
necessary, would be expected to occur in late 2008.





48





ITEM
1A.  RISK FACTORS





You
should consider carefully all of the information set forth in this report and,
in particular, the risk factors described below and those described in our
Annual Report on Form 10-K for the year ended December 31, 2007 and
certain of our other filings with the SEC. Those risks being described below,
elsewhere in this report on Form 10-Q and our other SEC filings are not the only
ones we face, but are considered to be the most material. There may be other
unknown or unpredictable economic, business, competitive, regulatory or other
factors that could have material adverse effects on our future results. Past
financial performance may not be a reliable indicator of future performance and
historical trends should not be used to anticipate results or trends in future
periods.







Risks
Related to Emergence from Bankruptcy







Our
actual financial results may vary significantly from the projections filed with
the Bankruptcy Court.










In
connection with the Plan of Reorganization process, we were required to prepare
projected financial information to demonstrate to the Bankruptcy Court the
feasibility of the Plan of Reorganization and our ability to continue operations
upon emergence from bankruptcy.  We filed projected financial
information with the Bankruptcy Court most recently on October 22, 2007 and
furnished it to the SEC, and as part of the disclosure statement approved by the
Bankruptcy Court.  The projections reflect numerous assumptions
concerning anticipated future performance and prevailing and anticipated market
and economic conditions that were and continue to be beyond our control and that
may not materialize.  Projections are inherently subject to
uncertainties and to a wide variety of significant business, economic and
competitive risks.  Our actual results will vary from those
contemplated by the projections for a variety of reasons, including the fact
that given our recent emergence from bankruptcy we have adopted the provisions
of AICPA SOP 90-7, Financial Reporting by Entities in
Reorganization under the Bankruptcy Code(“SOP 90-7”), regarding
fresh-start accounting.  As indicated in the disclosure statement, the
projections applied fresh-start accounting provisions.  However, these
projections were limited by the information available to us as of the date of
the preparation of the projections.  Therefore variations from the
projections may be material.  The projections have not been
incorporated by reference into this report and neither these projections nor any
version of the disclosure statement should be considered or relied upon in
connection with the purchase of our New Common Stock.







Because
our consolidated financial statements reflect fresh-start accounting adjustments
made upon emergence from bankruptcy, and because of the effects of the
transactions that became effective pursuant to the Plan of Reorganization,
financial information in our future financial statements will not be comparable
to our financial information from prior periods.







Upon our
emergence from Chapter 11, we adopted fresh-start accounting in accordance
with SOP 90-7, pursuant to which our reorganization value, which represents
the fair value of the entity before considering liabilities and approximates the
amount a willing buyer would pay for the assets of the entity immediately after
the reorganization, has been allocated to the fair value of assets in conformity
with Statement of Financial Accounting Standards No. 141, Business Combinations, using
the purchase method of accounting for business combinations.  We
stated liabilities, other than deferred taxes, at a present value of amounts
expected to be paid.  The amount remaining after allocation of the
reorganization value to the fair value of identified tangible and intangible
assets is reflected as goodwill, which is subject to periodic evaluation for
impairment.  In addition, under fresh-start accounting the accumulated
deficit has been eliminated.  In addition to fresh-start accounting,
our consolidated financial statements reflect all effects of the transactions
contemplated by the Plan of Reorganization.  Thus, our future
statements of financial position and statements of operations data will not be
comparable in many respects to our consolidated statements of financial position
and consolidated statements of operations data for periods prior to our adoption
of fresh-start accounting and prior to accounting for the effects of the
reorganization. The lack of comparable historical information may discourage
investors from purchasing our New Common Stock.





49








ITEM
6.  EXHIBITS





See
      the Exhibit Index at page 52 of this
  report.








50








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.








SOLUTIA
INC.


(Registrant)








/s/ TIMOTHY J.
SPIHLMAN


(Vice
President and Controller)


(On
behalf of the Registrant and as


Principal
Accounting Officer)





Dated:
July 30, 2008











51








EXHIBIT
INDEX





These
Exhibits are numbered in accordance with the Exhibit Table of Item 601 of
Regulation S-K.





EXHIBIT
              NUMBER
            
            DESCRIPTION3.1
            
            Second
      Amended and Restated Certificate of Incorporation of Solutia Inc.
      (incorporated by reference to Exhibit 3.1 to Solutia's Form 8-K filed on
      March 4, 2008)3.2
            
            Amended
      and Restated Bylaws of Solutia Inc. (incorporated by reference to Exhibit
      3.2 to Solutia's Form 8-K filed on March 4, 2008)10.1
            
            Joinder
      Agreement Supplement No. 1 dated as of May 5, 2008, to the Security
      Agreement (ABL)10.2
            
            Joinder
      Agreement Supplement No. 1 dated as of May 5, 2008, to the Security
      Agreement (Term)10.3
            
            Joinder
      Agreement Supplement No. 1 dated as of May 5, 2008, to the Guarantee
      Agreement (ABL)10.4
            
            Joinder
      Agreement Supplement No. 1 dated as of May 5, 2008, to the Guarantee
      Agreement (Term)10.5
            
            Joinder
      Agreement Supplement No. 1 dated as of May 5, 2008, to the Guarantee
      Agreement (Bridge)10.6
            
            Intercreditor
      Agreement Joinder dated as of May 5, 200810.7
            
            Solutia
      Inc. Savings and Investment Restoration Plan31.1
            
            Certification
      of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley
      Act of 200231.2
            
            Certification
      of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley
      Act of 200232.1
            
            Certification
      of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 as Adopted
      Pursuant to Section 906 of the Sarbanes-Oxley Act of
  200232.2
            
            Certification
      of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 as Adopted
      Pursuant to Section 906 of the Sarbanes-Oxley Act of
  2002