**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**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  SEPTEMBER 30, 2006** |
|   |   | **OR**                                                 |
| o      |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d)** |
|   |   | **OF THE SECURITIES EXCHANGE ACT OF 1934**             |
|   |   |                                                   |
|   |   | **Commission File Number 1-13953**                     |
|   |   |                                                   |

**W. R.GRACE & CO.**

| **Delaware**                                                |   | **65-0773649**       |
|-------------------------------------------------------------|--------|----------------------|
| (State of  Incorporation)                                   |   | (I.R.S. Employer     |
|                                                        |   | Identification  No.) |
|                                                        |   |                 |
| **7500  Grace Drive**                                       |
| **Columbia,  Maryland 21044**                               |
| **(410)  531-4000**                                         |
| (Address and  phone number of  principal executive offices) |
|                                                        |

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.
| Yes x |                            No o |   |
|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|

 

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer.  Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Exchange Act.

Large accelerated filer o                                    Acceleratedfiler x                             Non-acceleratedfiler o

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).
| Yes o |                            No x |   |
|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|       |                                                                                                                                                                        |   |

68,260,965 shares of Common Stock, $0.01 par value, were outstanding atOctober 31, 2006.

 

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**W. R. GRACE &CO. AND SUBSIDIARIES**

## Table of Contents

|               | ** ** | ** **                                                                                  | ** ** | ** **                 | **Page No.** | ** ** |
|---------------|------------|---------------------------------------------------------------------------------------------|------------|----------------------------|--------------|------------|
| **Part  I.**  | ** ** | ** **                                                                                  | ** ** | **Financial  Information** |         |       |
| Item  1.      |       | Financial  Statements                                                                       |       | I-1                        |
|          |       | Report of Independent Registered Public Accounting  Firm                                    |       | I-2                        |
|          |       | Consolidated Statements of Operations                                                       |       | I-3                        |
|          |       | Consolidated Statements of Cash Flows                                                       |       | I-4                        |
|          |       | Consolidated Balance Sheets                                                                 |       | I-5                        |
|          |       | Consolidated Statements of Shareholders’ Equity  (Deficit)                             |       | I-6                        |
|          |       | Consolidated Statements of Comprehensive Income (Loss)                                      |       | I-6                        |
|          |       | Notes to Consolidated Financial Statements                                                  |       | I-7                        |
| Item 2.       |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations |       | I-29                       |
| Item 3.       |       | Quantitative and Qualitative Disclosures About Market  Risk                                 |       | I-48                       |
| Item 4.       |       | Controls and Procedures                                                                     |       | I-51                       |
| **Part  II.** | ** ** | ** **                                                                                  | ** ** | **Other  Information**     |         |       |
| Item  1.      |       | Legal  Proceedings                                                                          |       | II-1                       |
| Item  1A.     |       | Risk  Factors                                                                               |       | II-1                       |
| Item 6.       |       | Exhibits                                                                                    |       | II-1                       |
|               |            |                                                                                             |            |                            |              |            |  |  |  |  |

 

----

 

**PART I.  FINANCIAL INFORMATION**

**Item 1.**                          FINANCIALSTATEMENTS

Review by Independent Registered Public AccountingFirm

With respect to theinterim consolidated financial statements included in this Quarterly Report onForm 10-Q for the three and nine months ended September 30, 2006 and 2005,PricewaterhouseCoopers LLP, the company’s independent registered publicaccounting firm, has applied limited procedures in accordance with professionalstandards for a review of such information. Their report on the interim consolidated financial statements, whichfollows, states that they did not audit and they do not express an opinion onthe unaudited interim financial statements. Accordingly, the degree of reliance on their report on the unauditedinterim financial statements should be restricted in light of the limitednature of the review procedures applied. This report is not considered a “report” within the meaning of Sections7 and 11 of the Securities Act of 1933, and, therefore, the independentaccountants’ liability under Section 11 does not extend to it.

 

I-1

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**Report ofIndependent Registered Public Accounting Firm**

**To theShareholders and Board of Directors of W. R. Grace & Co.:**

We have reviewed the accompanying consolidated balance sheet of W. R.Grace & Co. and its subsidiaries as of September 30, 2006, and the relatedconsolidated statements of operations, shareholders’ equity (deficit) andcomprehensive income (loss) for each of the three-month and nine-month periodsended September 30, 2006 and September 30, 2005 and the consolidated statementsof cash flows for the nine-month periods ended September 30, 2006 and September30, 2005. These interim financial statements are the responsibility of theCompany’s management.

Weconducted our review in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). A review of interim financialinformation consists principally of applying analytical procedures and makinginquiries of persons responsible for financial and accounting matters. It issubstantially less in scope than an audit conducted in accordance with thestandards of the Public Company Accounting Oversight Board (United States), theobjective of which is the expression of an opinion regarding the financialstatements taken as a whole. Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modificationsthat should be made to the accompanying interim consolidated financialstatements for them to be in conformity with accounting principles generallyaccepted in the United States of America.

The accompanying interim consolidated financial statements have beenprepared assuming that the Company will continue as a going concern.  As discussed in Notes 1 and 2 to the interimconsolidated financial statements, on April 2, 2001, the Company andsubstantially all of its domestic subsidiaries voluntarily filed for protectionunder Chapter 11 of the United States Bankruptcy Code, which raises substantialdoubt about the Company’s ability to continue as a going concern in its presentform.  Management’s intentions withrespect to this matter are also described in Notes 1 and 2.  The accompanying interim consolidatedfinancial statements do not include any adjustments that might result from theoutcome of this uncertainty.

We have previously audited, in accordance with the standards of thePublic Company Accounting Oversight Board (United States), the consolidatedbalance sheet as of December 31, 2005, and the related consolidated statementsof operations, cash flows, shareholders’ equity (deficit) and comprehensiveincome (loss) for the year then ended, management’s assessment of theeffectiveness of the Company’s internal control over financial reporting as ofDecember 31, 2005 and the effectiveness of the Company’s internal control overfinancial reporting as of December 31, 2005; and in our report dated March 10,2006, we expressed (i) an unqualified opinion on those consolidated financialstatements with an explanatory paragraph relating to the Company’s ability tocontinue as a going concern and, (ii) unqualified opinions on management’sassessment of the effectiveness of the Company’s internal control overfinancial reporting and on the effectiveness of the Company’s internal controlover financial reporting. The consolidated financial statements and management’sassessment of the effectiveness of internal control over financial reportingreferred to above are not presented herein. In our opinion, the information setforth in the accompanying consolidated balance sheet as of December 31, 2005,is fairly stated in all material respects in relation to the consolidatedbalance sheet from which it has been derived.

# /s/ PRICEWATERHOUSECOOPERS LLPMcLean, VirginiaNovember8, 2006

 

I-2

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**W. R. Grace & Co. and SubsidiariesConsolidated Statements of Operations (Unaudited)***In millions, except per share amounts*
| ** **                                                                                                                                | ** ** | ** **                                           | ** ** | ** **                                          | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                                                | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
| ** **                                                                                                                                | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                                                                                      |       |                                                 |       |                                                |       |   |   |   |   |
| Net sales                                                                                                                                 | ** ** | **$**                                                | **741.4**  |                                                | $          | 653.4 | ** ** | **$** | **2,129.1** |   | $ | 1,933.1 |   |
|                                                                                                                                      |       |                                                 |       |                                                |       |   |   |   |   |
| Cost of goods sold,  exclusive of depreciation and amortization shown separately below                                                    | ** ** | **483.8**                                            |       | 426.0                                               | ** ** | **1,392.0** |   | 1,258.4 |   |
| Selling, general and  administrative expenses, exclusive of net pension expense and depreciation  and amortization shown separately below | ** ** | **148.6**                                            |       | 109.5                                               | ** ** | **418.3** |   | 344.9 |   |
| Depreciation and  amortization                                                                                                            | ** ** | **29.2**                                             |       | 30.5                                                | ** ** | **85.7** |   | 91.2 |   |
| Research and  development expenses                                                                                                        | ** ** | **15.5**                                             |       | 14.9                                                | ** ** | **46.1** |   | 45.1 |   |
| Net pension expense                                                                                                                       | ** ** | **15.9**                                             |       | 17.3                                                | ** ** | **47.5** |   | 54.4 |   |
| Interest expense and  related financing costs                                                                                             | ** ** | **18.8**                                             |       | 13.4                                                | ** ** | **54.5** |   | 41.3 |   |
| Provision for  environmental remediation                                                                                                  | ** ** | **—**                                           |       | —                                              | ** ** | **30.0** |   | — |   |
| Other (income) expense                                                                                                                    | ** ** | **(6.3**                                             | **)**      | (4.4                                                | )          | **(22.1** | **)** | (34.4 | ) |
|                                                                                                                                      | ** ** | **705.5**                                            |       | 607.2                                               | ** ** | **2,052.0** |   | 1,800.9 |   |
| Income (loss) before  Chapter 11 expenses, income taxes, and minority interest                                                            | ** ** | **35.9**                                             |       | 46.2                                                | ** ** | **77.1** |   | 132.2 |   |
| Chapter 11 expenses,  net                                                                                                                 | ** ** | **(12.0**                                            | **)**      | (9.3                                                | )          | **(32.2** | **)** | (19.9 | ) |
| Income (loss) before  income taxes and minority interest                                                                                  | ** ** | **23.9**                                             |       | 36.9                                                | ** ** | **44.9** |   | 112.3 |   |
| Benefit from (provision  for) income taxes                                                                                                | ** ** | **2.4**                                              |       | 2.6                                                 | ** ** | **(5.4** | **)** | (26.0 | ) |
| Minority interest in  consolidated entities                                                                                               | ** ** | **(7.9**                                             | **)**      | (7.4                                                | )          | **(26.2** | **)** | (18.4 | ) |
| **Net  income (loss)**                                                                                                                    | ** ** | **$**                                                | **18.4**   |                                                | $          | 32.1 | ** ** | **$** | **13.3** |   | $ | 67.9 |   |
|                                                                                                                                      |       |                                                 |       |                                                |       |   |   |   |   |
| **Basic earnings (loss) per  share:**                                                                                                     | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income  (loss)                                                                                                                        | ** ** | **$**                                                | **0.27**   |                                                | $          | 0.48 | ** ** | **$** | **0.20** |   | $ | 1.02 |   |
| Weighted average  number of basic shares                                                                                                  | ** ** | **68.3**                                             |       | 66.9                                                | ** ** | **67.7** |   | 66.8 |   |
| ** **                                                                                                                                | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Diluted earnings (loss) per  share:**                                                                                                   |       |                                                 |       |                                                |       |   |   |   |   |
| Net income  (loss)                                                                                                                        | ** ** | **$**                                                | **0.27**   |                                                | $          | 0.48 | ** ** | **$** | **0.20** |   | $ | 1.01 |   |
| Weighted average number  of diluted shares                                                                                                | ** ** | **68.5**                                             |       | 67.2                                                | ** ** | **68.1** |   | 67.3 |   |

 

The Notes to ConsolidatedFinancial Statements are an integral part of these statements.

I-3

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**W. R. Grace & Co. and SubsidiariesConsolidated Statements of Cash Flows (Unaudited)***In millions*
| ** **                                                                                                                   | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                                   | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| **OPERATING ACTIVITIES**                                                                                                     | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Net income  (loss)                                                                                                           | ** ** | **$**                                               | **13.3**   |   | $ | 67.9 |   |
| Reconciliation  to net cash provided by (used for) operating activities:                                                     |       |                                                |       |   |   |
| Chapter 11 expenses, net                                                                                                     | ** ** | **32.2**                                            |       | 19.9 |   |
| (Benefit from) provision for income taxes                                                                                    | ** ** | **5.4**                                             |       | 26.0 |   |
| Minority interest in consolidated entities                                                                                   | ** ** | **26.2**                                            |       | 18.4 |   |
| Depreciation and amortization                                                                                                | ** ** | **85.7**                                            |       | 91.2 |   |
| Interest accrued on pre-petition liabilities subject  to compromise                                                          | ** ** | **53.1**                                            |       | 37.7 |   |
| Net (gain) loss on sales of investments and  disposals of assets                                                             | ** ** | **(2.6**                                            | **)**      | (0.2 | ) |
| Loss on sale of business                                                                                                     | ** ** | **—**                                          |       | 1.1 |   |
| Net pension expense                                                                                                          | ** ** | **47.5**                                            |       | 54.4 |   |
| Payments to fund defined benefit pension  arrangements                                                                       | ** ** | **(109.5**                                          | **)**      | (32.8 | ) |
| Net income from life insurance policies                                                                                      | ** ** | **(2.2**                                            | **)**      | (1.6 | ) |
| Provision for uncollectible receivables                                                                                      | ** ** | **3.2**                                             |       | 2.2 |   |
| Provision for environmental remediation                                                                                      | ** ** | **30.0**                                            |       | — |   |
| Payments under postretirement benefit plans                                                                                  | ** ** | **(10.7**                                           | **)**      | (8.3 | ) |
| Expenditures for environmental remediation                                                                                   | ** ** | **(8.7**                                            | **)**      | (4.7 | ) |
| Expenditures for retained obligations of divested  businesses                                                                | ** ** | **(2.7**                                            | **)**      | (0.7 | ) |
| Changes in assets and liabilities, excluding effect  of businesses acquired/divested and foreign currency translation:       |       |                                                |       |   |   |
| Working capital items (trade accounts receivable,  inventories and accounts payable)                                         | ** ** | **(59.7**                                           | **)**      | (60.8 | ) |
| Other accruals and non-cash items                                                                                            | ** ** | **11.5**                                            |       | (33.4 | ) |
| Income taxes paid, net of refunds                                                                                            | ** ** | **(36.2**                                           | **)**      | (27.8 | ) |
| **Net cash provided by (used for) operating  activities before Chapter 11 expenses and settlement of noncore contingencies** | ** ** | **75.8**                                            |       | 148.5 |   |
| Cash paid to  settle noncore contingencies                                                                                   | ** ** | **—**                                          |       | (119.7 | ) |
| Chapter 11  expenses paid                                                                                                    | ** ** | **(26.4**                                           | **)**      | (14.0 | ) |
| **Net cash provided by (used for) operating  activities**                                                                    | ** ** | **49.4**                                            |       | 14.8 |   |
| **INVESTING ACTIVITIES**                                                                                                     | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Capital  expenditures                                                                                                        | ** ** | **(82.5**                                           | **)**      | (59.2 | ) |
| Businesses  acquired, net of cash acquired                                                                                   | ** ** | **(20.0**                                           | **)**      | (2.5 | ) |
| Proceeds from  termination of life insurance policies                                                                        | ** ** | **—**                                          |       | 14.8 |   |
| Net investment  in life insurance policies                                                                                   | ** ** | **0.2**                                             |       | 0.4 |   |
| Proceeds from  sales of investments and disposals of assets                                                                  | ** ** | **7.3**                                             |       | 1.7 |   |
| Proceeds from  sale of business                                                                                              | ** ** | **—**                                          |       | 4.5 |   |
| **Net cash provided by (used for) investing  activities**                                                                    | ** ** | **(95.0**                                           | **)**      | (40.3 | ) |
| **FINANCING ACTIVITIES**                                                                                                     | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Net payments of  loans secured by cash value of life insurance policies                                                      | ** ** | **(0.1**                                            | **)**      | (0.5 | ) |
| Net (repayments)  borrowings under credit arrangements                                                                       | ** ** | **0.5**                                             |       | (9.7 | ) |
| Fees under  debtor-in-possession credit facility                                                                             | ** ** | **(1.8**                                            | **)**      | (1.5 | ) |
| Proceeds from  exercise of stock options                                                                                     | ** ** | **15.8**                                            |       | 3.1 |   |
| **Net cash provided by (used for) financing  activities**                                                                    | ** ** | **14.4**                                            |       | (8.6 | ) |
| Effect of  currency exchange rate changes on cash and cash equivalents                                                       | ** ** | **10.2**                                            |       | (12.8 | ) |
| **Increase (decrease) in cash and cash equivalents**                                                                         | ** ** | **(21.0**                                           | **)**      | (46.9 | ) |
| Cash and cash  equivalents, beginning of period                                                                              | ** ** | **474.7**                                           |       | 510.4 |   |
| Cash and cash  equivalents, end of period                                                                                    | ** ** | **$**                                               | **453.7**  |   | $ | 463.5 |   |

 

The Notes to ConsolidatedFinancial Statements are an integral part of these statements.

 

I-4

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**W. R. Grace & Co. andSubsidiariesConsolidated Balance Sheets (Unaudited)***In millions, except par value and shares*

** **
| ** **                                                                                                                      | ** ** | **September 30,** | ** **  | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|-------------|-----------------------|------------|
| ** **                                                                                                                      | ** ** | **2006**               | ** **  | **2005**              | ** ** |
| **ASSETS**                                                                                                                      | ** ** | ** **             |        |                  |       |
| ** **                                                                                                                      | ** ** | ** **             |        |                  |       |
| **Current Assets**                                                                                                              | ** ** | ** **             |        |                  |       |
| Cash and cash  equivalents                                                                                                      | ** ** | **$**                  | **453.7**   |                  | $          | 474.7 |   |
| Trade accounts  receivable, less allowance of $7.3 (2005–$5.0)                                                             | ** ** | **486.5**              |        | 401.7                 |       |
| Inventories                                                                                                                     | ** ** | **287.4**              |        | 278.3                 |       |
| Deferred income taxes                                                                                                           | ** ** | **29.3**               |        | 27.3                  |       |
| Other current assets                                                                                                            | ** ** | **56.3**               |        | 71.6                  |       |
| **Total  Current Assets**                                                                                                       | ** ** | **1,313.2**            |        | 1,253.6               |       |
|                                                                                                                            | ** ** | ** **             |        |                  |       |
| Properties and  equipment, net of accumulated depreciation and amortization of $1,504.8 (2005–$1,420.2)                    | ** ** | **650.8**              |        | 632.9                 |       |
| Goodwill                                                                                                                        | ** ** | **114.0**              |        | 103.9                 |       |
| Cash value of life  insurance policies, net of policy loans                                                                     | ** ** | **86.9**               |        | 84.8                  |       |
| Deferred income taxes                                                                                                           | ** ** | **737.2**              |        | 703.9                 |       |
| Asbestos-related  insurance                                                                                                     | ** ** | **500.0**              |        | 500.0                 |       |
| Other assets                                                                                                                    | ** ** | **238.6**              |        | 238.1                 |       |
| **Total  Assets**                                                                                                               | ** ** | **$**                  | **3,640.7** | ** **            | $          | 3,517.2 |   |
| ** **                                                                                                                      | ** ** | ** **             |        |                  |       |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY (DEFICIT)**                                                                        | ** ** | ** **             |        |                  |       |
| ** **                                                                                                                      | ** ** | ** **             |        |                  |       |
| **Liabilities Not Subject to  Compromise**                                                                                      | ** ** | ** **             |        |                  |       |
| **Current Liabilities**                                                                                                         | ** ** | ** **             |        |                  |       |
| Debt payable within one  year                                                                                                   | ** ** | **$**                  | **3.2**     |                  | $          | 2.3 |   |
| Accounts payable                                                                                                                | ** ** | **179.8**              |        | 166.8                 |       |
| Income taxes payable                                                                                                            | ** ** | **5.8**                |        | 10.1                  |       |
| Other current  liabilities                                                                                                      | ** ** | **222.4**              |        | 197.9                 |       |
| **Total  Current Liabilities**                                                                                                  | ** ** | **411.2**              |        | 377.1                 |       |
|                                                                                                                            | ** ** | ** **             |        |                  |       |
| Debt payable after one  year                                                                                                    | ** ** | **0.4**                |        | 0.4                   |       |
| Deferred income taxes                                                                                                           | ** ** | **63.2**               |        | 54.3                  |       |
| Minority interest in  consolidated affiliates                                                                                   | ** ** | **63.6**               |        | 36.4                  |       |
| Unfunded defined  benefit pension liability                                                                                     | ** ** | **392.6**              |        | 447.5                 |       |
| Other liabilities                                                                                                               | ** ** | **42.2**               |        | 41.7                  |       |
| **Total  Liabilities Not Subject to Compromise**                                                                                | ** ** | **973.2**              | ** **  | 957.4                 |       |
|                                                                                                                            | ** ** | ** **             | ** **  |                  |       |
| **Liabilities Subject to  Compromise—Note 2**                                                                              | ** ** | **3,211.6**            |        | 3,155.1               |       |
| **Total  Liabilities**                                                                                                          | ** ** | **4,184.8**            |        | 4,112.5               |       |
| ** **                                                                                                                      | ** ** | ** **             |        |                  |       |
| **Commitments and Contingencies**                                                                                               | ** ** | ** **             |        |                  |       |
| ** **                                                                                                                      | ** ** | ** **             |        |                  |       |
| **Shareholders’ Equity (Deficit)**                                                                                         | ** ** | ** **             |        |                  |       |
| Common stock issued,  par value $0.01; 300,000,000 shares authorized; outstanding: 2006–68,260,065  (2005–66,922,196) | ** ** | **0.8**                |        | 0.8                   |       |
| Paid-in capital                                                                                                                 | ** ** | **423.2**              |        | 423.4                 |       |
| Accumulated deficit                                                                                                             | ** ** | **(492.6**             | **)**       | (505.9                | )          |
| Treasury stock, at  cost: shares: 2006–8,719,695; (2005–10,057,564)                                                   | ** ** | **(103.8**             | **)**       | (119.7                | )          |
| Accumulated other  comprehensive income (loss)                                                                                  | ** ** | **(371.7**             | **)**       | (393.9                | )          |
| **Total  Shareholders’ Equity (Deficit)**                                                                                  | ** ** | **(544.1**             | **)**       | (595.3                | )          |
| **Total Liabilities and  Shareholders’ Equity (Deficit)**                                                                  | ** ** | **$**                  | **3,640.7** | ** **            | $          | 3,517.2 |   |

 

The Notes to ConsolidatedFinancial Statements are an integral part of these statements.

I-5

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**W. R. Grace & Co. and SubsidiariesConsolidated Statements of Shareholders’ Equity (Deficit) (Unaudited)***In millions*

** **
| ** **                         | ** ** | **Common  Stock and  Paid-in Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Treasury  Stock** | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** | **Total  Shareholders’  Equity  (Deficit)** | ** ** |
|------------------------------------|------------|--------------------------------------------------|------------|--------------------------|------------|---------------------|------------|-----------------------------------------------------------|------------|--------------------------------------------------|------------|
| **Balance,  June 30, 2006**        |       | $                                                | 424.0      |                     | $          | (511.0              | )          | $                                                         | (103.8     | )                                                | $          | (379.6 | ) | $ | (570.4 | ) |
| Net income  (loss)                 |       | —                                           |       | 18.4                     |       | —              |       | —                                                    |       | 18.4                                             |       |
| Stock plan  activity               |       | —                                           |       | —                   |       | —              |       | —                                                    |       | —                                           |       |
| Other  comprehensive income (loss) |       | —                                           |       | —                   |       | —              |       | 7.9                                                       |       | 7.9                                              |       |
| **Balance,  September 30, 2006**   | ** ** | **$**                                            | **424.0**  | ** **               | **$**      | **(492.6**          | **)**      | **$**                                                     | **(103.8** | **)**                                            | **$**      | **(371.7** | **)** | **$** | **(544.1** | **)** |
| ** **                         |       |                                             |       |                     |       |                |       |                                                      |       |                                             |       |
| **Balance,  December 31, 2005**    |       | $                                                | 424.2      |                     | $          | (505.9              | )          | $                                                         | (119.7     | )                                                | $          | (393.9 | ) | $ | (595.3 | ) |
| Net income  (loss)                 |       | —                                           |       | 13.3                     |       | —              |       | —                                                    |       | 13.3                                             |       |
| Stock plan  activity               |       | (0.2                                             | )          | —                   |       | 15.9                |       | —                                                    |       | 15.7                                             |       |
| Other  comprehensive income (loss) |       | —                                           |       | —                   |       | —              |       | 22.2                                                      |       | 22.2                                             |       |
| **Balance, September 30, 2006**    | ** ** | **$**                                            | **424.0**  | ** **               | **$**      | **(492.6**          | **)**      | **$**                                                     | **(103.8** | **)**                                            | **$**      | **(371.7** | **)** | **$** | **(544.1** | **)** |

 

**W. R. Grace & Co. and SubsidiariesConsolidated Statements of Comprehensive Income (Loss) (Unaudited)***In millions*
| ** **                                | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Net  income (loss)**                    | ** ** | **$**                                                | **18.4**   |                                                | $          | 32.1 | ** ** | **$** | **13.3** |   | $ | 67.9 |   |
|                                      | ** ** | ** **                                           | ** ** | ** **                                          |       |   |   |   |   |
| **Other  comprehensive income (loss):**   | ** ** | ** **                                           | ** ** | ** **                                          |       |   |   |   |   |
| Foreign currency  translation adjustments | ** ** | **8.3**                                              |       | (0.9                                                | )          | **22.9** |   | (23.3 | ) |
| Commodity  hedging activities             | ** ** | **(0.4**                                             | **)**      | —                                              | ** ** | **(0.7** | **)** | — |   |
| Total other comprehensive  income (loss)  | ** ** | **7.9**                                              |       | (0.9                                                | )          | **22.2** |   | (23.3 | ) |
| **Comprehensive income (loss)**           | ** ** | **$**                                                | **26.3**   |                                                | $          | 31.2 | ** ** | **$** | **35.5** |   | $ | 44.6 |   |

 

The Notes to Consolidated Financial Statements are anintegral part of these statements.

 

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**W. R. Grace & Co. and SubsidiariesNotes to Consolidated Financial Statements (Unaudited)**

**1.              Basis of Presentation and Summaryof Significant Accounting and Financial Reporting Policies**

W. R. Grace& Co., through its subsidiaries, is engaged in specialty chemicals andspecialty materials businesses on a worldwide basis through two operatingsegments: “Grace Davison,” which includes silica- and alumina-based catalystsand materials used in a wide range of industrial applications; and “GracePerformance Chemicals,” which includes specialty chemicals and materials usedin commercial and residential construction and in rigid food and beveragepackaging.

W. R. Grace& Co. conducts substantially all of its business through a direct,wholly-owned subsidiary, W. R. Grace & Co.-Conn. (“Grace-Conn.”).Grace-Conn. owns substantially all of the assets, properties and rights of W. R. Grace& Co. on a consolidated basis, either directly or through subsidiaries.

As used in thesenotes, the term “Company” refers to W. R. Grace & Co. The term “Grace”refers to the Company and/or one or more of its subsidiaries and, in certaincases, their respective predecessors.

***Voluntary Bankruptcy Filing***—During2000 and the first quarter of 2001, Grace experienced several adversedevelopments in its asbestos-related litigation, including: a significantincrease in personal injury claims, higher than expected costs to resolvepersonal injury and certain property damage claims, and class action lawsuitsalleging damages from Zonolite Attic Insulation (“ZAI”) a former Grace atticinsulation product.

After a thoroughreview of these developments, the Board of Directors concluded that a federalcourt-supervised bankruptcy process provided the best forum available toachieve fairness in resolving these claims and on April 2, 2001 (the “Filing Date”),Grace and 61 of its United States subsidiaries and affiliates, includingGrace-Conn. (collectively, the “Debtors”), filed voluntary petitions forreorganization (the “Filing”) under Chapter 11 of the United StatesBankruptcy Code in the United States Bankruptcy Court for the District ofDelaware (the “Bankruptcy Court”). The cases were consolidated and are beingjointly administered under case number 01-01139 (the “Chapter 11Cases”). Grace’s non-U.S. subsidiaries and certain of its U.S. subsidiarieswere not included in the Filing.

Under Chapter 11,the Debtors have continued to operate their businesses as debtors-in-possessionunder court protection from creditors and claimants, while using the Chapter 11process to develop and implement a plan for addressing the asbestos-relatedclaims. Since the Filing, all motions necessary to conduct normal businessactivities have been approved by the Bankruptcy Court. (See Note 2 for Chapter 11-RelatedInformation.)

***Basis of Presentation***—The interim Consolidated Financial Statementspresented herein are unaudited and should be read in conjunction with theConsolidated Financial Statements presented in the Company’s 2005 Annual Reporton Form 10-K.  Such interim ConsolidatedFinancial Statements reflect all adjustments that, in the opinion ofmanagement, are necessary for a fair presentation of the results of the interimperiods presented; all such adjustments are of a normal recurring nature.Potential accounting adjustments discovered during normal reporting andaccounting processes are evaluated on the basis of materiality, bothindividually and in the aggregate, and are recorded in the accounting perioddiscovered, unless a restatement of a prior period is necessary. Allsignificant intercompany accounts and transactions have been eliminated.

The results ofoperations for the three-month and nine-month interim periods ended September 30,2006 are not necessarily indicative of the results of operations for the year endingDecember 31, 2006.

***Reclassifications***—Certain amounts inprior years’ Consolidated Financial Statements have been reclassified toconform to the 2006 presentation.  Suchreclassifications have not materially affected previously reported amounts inthe Consolidated Financial Statements.

***Use of Estimates***—The preparation offinancial statements in conformity with U.S. generally accepted accountingprinciples requires that management make estimates and assumptions affectingthe assets and liabilities reported at the date of the Consolidated FinancialStatements, and the revenues and expenses reported for the periods presented.Actual amounts could differ from those estimates, and the differences could be 

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material.  Changes in estimates are recorded in theperiod identified. Grace’s accounting measurements that are most affected bymanagement’s estimates of future events are:

·                  Contingentliabilities which depend on an assessment of the probability of loss and anestimate of ultimate resolution cost, such as asbestos-related matters (seeNotes 2 and 3), environmental remediation (see Note 12), incometaxes (see Note 12), and litigation (see Note 12);

·                  Pensionand postretirement liabilities that depend on assumptions regarding participantlife spans, future inflation, discount rates and total returns on investedfunds (see Note 13);

·                  Liabilitiesfor employee incentive compensation and customer rebates that depend onestimates of future sales or earnings;

·                  Depreciationand amortization periods for long-lived assets, including property andequipment, intangible, and other assets that depend on utilization assessments,future product and production plans and expected sales and cash flows; and

·                  Realizationvalues of various assets such as net deferred tax assets, trade receivables,inventories, insurance receivables, properties and equipment, and goodwillwhich depend on assessments of credit and other business risks, and projectionsof future income and cash flows.

The accuracy ofthese and other estimates may also be materially affected by the uncertaintiesarising under Grace’s Chapter 11 proceeding.

***Effect of New Accounting Standards***—In September 2006, the FinancialAccounting Standards Board (“FASB”) issued Statement of Financial AccountingStandards (“SFAS”) No. 158, “Employers’ Accounting for Defined BenefitPension and Other Postretirement Plans.” SFAS No. 158 requires an employer to recognize the funded status ofdefined benefit pension plans and other postretirement benefit plans as anasset or liability in its statement of financial position, and requiresrecognition in other comprehensive income of gains or losses and prior servicecosts or credits arising during the period but which are not included ascomponents of net periodic benefit cost. SFAS No. 158 is effective for the year ending December 31,2006.  Grace is not currently able toquantify the estimated effects of the adoption of SFAS No. 158 to itsstatement of financial position, as actual amounts will depend on year-endassumptions and calculations.  If Gracehad adopted SFAS No. 158 effective December 31, 2005, Grace estimatesthat, after tax effects, reported total assets would have decreased byapproximately $55 million, reported total liabilities would have increasedby approximately $43 million, and reported total shareholders’ deficitwould have increased by approximately $98 million.  Grace does not expect adoption of SFAS No. 158to have a material impact on its consolidated results of operations.

In June 2006, theFASB issued Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes” (“FIN 48”), which prescribes a recognition threshold and measurementattribute for tax positions taken or expected to be taken in tax returns.  FIN 48 also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure, and transition. Grace is required to adopt FIN 48 in the first quarter of 2007, and iscurrently evaluating the impact to its Consolidated Financial Statements.

In December 2004,the FASB issued SFAS No. 123(R), “Share-Based Payment,” to requirecompanies to measure and recognize in operations the cost of employee servicesreceived in exchange for an award of equity instruments based on the grant-datefair value. The provisions of this standard are effective for Grace in 2006.Grace implemented SFAS 123(R) in the first quarter of 2006. Under thetransition method selected by Grace, the modified prospective method, the onlyoutstanding awards affected were stock appreciation rights granted to Grace’sformer Chief Executive Officer. Grace measured the award at a fair value of$2.6 million using the Black-Scholes option pricing model at March 31,2006 and recorded that amount as compensation cost (included in selling,general and administrative expenses) in the quarter ended March 31, 2006.  Grace recognized a $0.6 million decreaseand a $0.4 million increase in the fair value of the stock appreciationrights in the quarters ended June 30, 2006 and September 30, 2006,respectively.  The cumulative effect ofthis new rule was $1.4 million 

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at the beginningof the first quarter of 2006. Grace has not granted equity options or rightswhile in Chapter 11.

In November 2004,the FASB issued SFAS No. 151, “Inventory Costs—an Amendment of ARB No. 43,Chapter 4,” to provide clarification that abnormal amounts of idlefacility expense, freight, handling costs, and wasted material be recognized ascurrent-period costs. In addition, this standard requires that the allocationof fixed production overheads to the costs of inventory be based on the normalcapacity of the production facilities. Grace adopted this standard in 2006 and it has not had a material impacton Grace’s Consolidated Financial Statements. 

 

**2.         Chapter 11-RelatedInformation**

***Official Parties toGrace’s Chapter 11 Proceedings***—Three creditors’committees, two representing asbestos claimants and the third representingother unsecured creditors, and a committee representing shareholders, have beenappointed in the Chapter 11 Cases. These committees, and a legalrepresentative of future asbestos claimants, have the right to be heard on allmatters that come before the Bankruptcy Court and are likely to play importantroles in the Chapter 11 Cases. The Debtors are required to bear certaincosts and expenses of the committees and of the representative of futureasbestos claimants, including those of their counsel and financial advisors.

***Plan of Reorganization***—OnNovember 13, 2004 Grace filed a plan of reorganization, as well as severalassociated documents, including a disclosure statement, with the BankruptcyCourt.  On January 13, 2005, Grace filedan amended plan of reorganization (the “Plan”) and related documents to addresscertain objections of creditors and other interested parties. The Plan issupported by committees representing general unsecured creditors and equityholders, but is not supported by committees representing asbestos personalinjury claimants and asbestos property damage claimants or the representativeof future asbestos claimants.

Underthe terms of the Plan, a trust would be established under Section 524(g)of the Bankruptcy Code to which all pending and future asbestos-related claimswould be channeled for resolution.  Gracehas requested that the Bankruptcy Court conduct an estimation hearing to, amongother things, determine the amount that would need to be paid into the trust onthe effective date of the Plan to satisfy the estimated liability for all classesof asbestos claimants and trust administration costs and expenses over time.The Plan provides that Grace’s asbestos-related liabilities would be satisfiedusing cash and securities from Grace and third parties.

The Plan will become effective only after a vote of eligible creditorsand with the approval of the Bankruptcy Court and the U.S. District Court forthe District of Delaware. Votes on the Plan may not be solicited until theBankruptcy Court approves the disclosure statement. The Bankruptcy Court hascurrently deferred consideration of the disclosure statement and Plan untilafter completion of estimation hearings on the amount of Grace’sasbestos-related liability. The Debtors have received extensions oftheir exclusive right to propose a plan of reorganization through July 23,2007.  The asbestos claimants committeesand the representative of future asbestos claimants have appealed the latestextension of exclusivity to the U.S. District Court for the District ofDelaware.

Under the terms of the Plan, claims would be satisfied under the Chapter 11Cases as follows:

Asbestos-RelatedClaims and Costs

**A trust would be established under Section 524(g)of the Bankruptcy Code to which all pending and future asbestos-related claimswould be channeled for resolution.**  The trustwould utilize specified trust distribution procedures to satisfy the followingallowed asbestos-related claims and costs:

**1.**                           *Personal injury claims that meet specified exposure and medicalcriteria (Personal Injury—Symptomatic Eligible or “PI-SE” Claims)—*In order to qualify for this class, claimantswould have to prove that their health is impaired from meaningful exposure toasbestos-containing products formerly manufactured by Grace.

**2.**                           *Personal injury claims that do not meet the exposureand medical criteria necessary to qualify as PI-SE Claims (PersonalInjury-Asymptomatic and Other or “PI-AO” Claims)—*This class would contain all asbestos-related personal injury claimsagainst Grace that do not meet the specific requirements to be PI-SE Claims,but do meet certain other specified exposure and medical criteria.

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**3.**                           *Property damage claims, including claims related to ZAI(“PD Claims”)*—In order to qualify for thisclass, claimants would have to prove Grace liability for loss of property valueor remediation costs related to products formerly manufactured by Grace thatclaimants allege contained asbestos.

**4.**                           *Trust administration costs and legal expenses*

**The pending asbestos-relatedlegal proceedings are described in “Asbestos-Related Litigation” (see Note 3).The claims arising from such proceedings would be subject to thisclassification process as part of the Plan.**

**The Bankruptcy Court has enteredseparate case management orders for estimating liability for pending and futurepersonal injury claims and adjudicating pending property damage claims,excluding ZAI claims.**Trial dates for estimating liability for personalinjury claims have been scheduled for June 2007.  Hearings for the adjudication of variousissues regarding property damage claims are currently scheduled to take placeduring the first and second quarters of 2007. The Debtors expect that the estimated liability will provide the basisfor determining the Funding Amount to be paid into the trust on the effectivedate of the Plan.

**Asbestos personal injuryclaimants, including both PI-SE and PI-AO claims, would have the option eitherto litigate their claims against the trust in federal court in Delaware or, ifthey meet specified eligibility criteria, accept a settlement amount based onthe severity of their condition. Asbestos property damage claimants would berequired to litigate their claims against the trust in federal court inDelaware. The Plan provides that, as a condition precedent to confirmation, themaximum estimated aggregate funding amount for all asbestos-related liabilities(PI-SE, PI-AO and PD including ZAI) and trust administration costs and expensesas determined by the Bankruptcy Court cannot exceed $1,613 million, whichGrace believes would fund over $2 billion in claims, costs and expenses overtime.**

**The PI-SE Claims, the PD Claimsand the related trust administration costs and expenses would be funded with (1) apayment of $512.5 million in cash (plus interest at 5.5% compoundedannually from December 21, 2002) and nine million shares of commonstock of Sealed Air Corporation (“Sealed Air”) to be made directly by Cryovac,Inc., a wholly owned subsidiary of Sealed Air (“Cryovac”), to the asbestostrust pursuant to the terms of a settlement agreement resolvingasbestos-related, successor liability and fraudulent transfer claims againstSealed Air and Cryovac and (2) Grace common stock. The number of shares ofGrace common stock required to satisfy these claims will depend on the price ofGrace common stock on the effective date of the Plan, liability measuresapproved by the Bankruptcy Court, and the value of the Sealed Air settlement,which changes daily with the accrual of interest and the trading value ofSealed Air common stock. The Sealed Air settlement agreement has been approvedby the Bankruptcy Court, but remains subject to the fulfillment of specifiedconditions.**

**The PI-AO Claims would be fundedwith warrants exercisable for that number of shares of Grace common stockwhich, when added to the shares issued directly to the trust on the effectivedate of the Plan, would represent 50.1% of Grace’s voting securities. If thecommon stock issuable upon exercise of the warrants is insufficient to pay allPI-AO Claims (the liability for which is uncapped under the Plan), then Gracewould pay any additional liabilities in cash.**

**The amounts to fund PI-SE Claims,PD Claims and the expense of trust administration would be capped at the amountdetermined by the Bankruptcy Court. Amounts required to fund PI-AO Claims wouldnot be capped, so if the amount funded in respect thereof later proved to beinadequate, Grace would be responsible for contributing additional funds intothe asbestos trust to satisfy PI-AO Claims. Because of the number and nature of the uncertainties involved, Grace isunable to determine the extent to which, if any, the liability for PI-AO claimsmay exceed the amount funded into the trust in respect thereof.**

**Other Claims**

The Plan provides that allallowed administrative or priority claims would be paid 100% in cash and allgeneral unsecured claims, other than those covered by the asbestos trust, wouldbe paid 85% in cash and 15% in Grace common stock. Grace estimates that claimswith a recorded value of approximately $1,227 million, including interestaccrued through September 30, 2006, would be satisfied in this manner atthe effective date of the Plan. Grace would finance these payments with cash onhand, cash from Fresenius Medical Care Holdings, Inc. (“Fresenius”) paid insettlement of asbestos and other Grace-related claims, new 

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Grace debt, and Gracecommon stock.  Grace would satisfy othernon-asbestos related liabilities and claims (primarily certain environmental,tax, pension and retirement medical obligations) as they become due and payableover time using cash flow from operations, insurance proceeds frompolicies and settlement agreements covering asbestos-related liabilities, andnew credit facilities. Proceeds fromavailable product liability insurance applicable to asbestos-related claimswould supplement operating cash flow to service new debt and liabilities notpaid on the effective date of the Plan.

**Effect on Grace Common Stock**

**The Plan provides that Gracecommon stock will remain outstanding at the effective date of the Plan, butthat the interests of existing shareholders would be subject to dilution byadditional shares of common stock issued under the Plan. In addition, in orderto preserve significant tax benefits from net operating loss carryforwards (“NOLs”)and certain future deductions, which are subject to elimination or limitationin the event of a change in control (as defined by the Internal Revenue Code)of Grace, the Plan places restrictions on the purchase of Grace common stock.The restrictions would prohibit (without the consent of Grace), for a period ofthree years after the effective date of the Plan, a person or entity fromacquiring more than 4.75% of the outstanding Grace common stock or, for thosepersons already holding more than 4.75%, prohibit them from increasing ordecreasing their holdings. The Bankruptcy Court has also approved the tradingrestrictions described above, excluding the restriction on sales, until theeffective date of the Plan.**

**Grace intends to address allpending and future asbestos-related claims and all other pre-petition claims asoutlined in the Plan. However, Grace may not be successful in obtainingapproval of the Plan by the Bankruptcy Court and other interested parties. Forexample, the asbestos creditors committees and representative of futureasbestos claimants have challenged the confirmability of the Plan, arguing thatthe Plan impairs the rights of asbestos creditors and impermissibly denies themvoting rights, and have asserted that Grace’s asbestos-related liabilities exceedthe fair value of Grace’s assets.  As aresult of these challenges and other Bankruptcy Court rulings, a materiallydifferent plan of reorganization may ultimately be approved and, under theultimate plan of reorganization, the interests of the Company’s shareholderscould be substantially diluted or cancelled. The value of Grace common stockfollowing a plan of reorganization, and the extent of any recovery bynon-asbestos-related creditors, will depend principally on the allowed value ofGrace’s asbestos-related claims as determined by the Bankruptcy Court.**

***Claims Filings***—TheBankruptcy Court established a bar date of March 31, 2003 for claims of generalunsecured creditors, asbestos-related property damage claims (other than ZAIclaims) and medical monitoring claims related to asbestos. The bar date did notapply to asbestos-related personal injury claims or claims related to ZAI,which will be dealt with separately.

**Approximately 14,900 proofs ofclaim were filed by the March 31, 2003 bar date. Of these claims, approximately9,400 were non-asbestos related, approximately 4,300 were for asbestos-relatedproperty damage, and approximately 1,000 were for medical monitoring. Themedical monitoring claims were made by individuals who allege exposure to asbestosthrough Grace’s products or operations. These claims, if sustained, wouldrequire Grace to fund ongoing health monitoring costs for qualified claimants.In addition, approximately 800 proofs of claim were filed after the bar date.**

**Approximately 7,000 of thenon-asbestos related claims involve claims by employees or former employees forfuture retirement benefits such as pension and retiree medical coverage. Graceviews most of these claims as contingent and has proposed a plan ofreorganization that would retain such benefits. The other non-asbestos relatedclaims include claims for payment of goods and services, taxes, productwarranties, principal and interest under pre-petition credit facilities,amounts due under leases and other contracts, leases and other executorycontracts rejected in the Bankruptcy Court, environmental remediation,indemnification or contribution to actual or potential co-defendants inasbestos-related and other litigation, pending non-asbestos-related litigation,and non-asbestos-related personal injury.**

**The Debtors have analyzed theclaims as filed and have found that many are duplicates, represent the sameclaim filed against more than one of the Debtors, lack any supportingdocumentation, or provide insufficient supporting documentation. As of September 30,2006, the Debtors had filed objections to approximately 5,500 claims(approximately 100 of which were subsequently withdrawn), approximately 3,950of which were**

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**asbestos property damage claims.Of the 5,400 claims, approximately 2,300 have been expunged, approximately 250have been resolved, approximately 2,150 have been withdrawn by claimants, andthe remaining approximately 700 will be addressed through the claims objectionprocess and the dispute resolution procedures approved by the Bankruptcy Court.**

**Grace believes that its recordedliabilities for claims subject to the bar date represent a reasonable estimateof the ultimate allowable amount for claims that are not in dispute or havebeen submitted with sufficient information to both evaluate the merit andestimate the value of the claim. The asbestos-related claims are considered aspart of Grace’s overall asbestos liability and are being accounted for inaccordance with the conditions precedent under the Plan, as described in “AccountingImpact” below. As claims are** resolved, or where better information becomesavailable and is evaluated, Grace will make adjustments to the liabilitiesrecorded in its financial statements as appropriate. Any such adjustments couldbe material to its consolidated financial position and results of operations.

***Litigation Proceedings in Bankruptcy Court***—InSeptember 2000, Grace was named in a purported class action lawsuit filedin California Superior Court for the County of San Francisco, alleging that the1996 reorganization involving a predecessor of Grace and Fresenius AG and the1998 reorganization involving a predecessor of Grace and Sealed Air werefraudulent transfers. The Bankruptcy Court authorized the Official Committee ofAsbestos Personal Injury Claimants and the Official Committee of AsbestosProperty Damage Claimants to proceed with claims against Fresenius and SealedAir and Cryovac on behalf of the Debtors’ bankruptcy estate.

On November 29,2002, Sealed Air (and Cryovac) and Fresenius each announced that they hadreached agreements in principle with such Committees to settle asbestos,successor liability and fraudulent transfer claims related to such transactions(the “litigation settlement agreements”). Under the terms of the Freseniussettlement, subject to the fulfillment of certain conditions, Fresenius wouldpay $115.0 million to the Debtors’ estate as directed by the BankruptcyCourt upon confirmation of the Debtors’ plan of reorganization. In July 2003,the Fresenius settlement was approved by the Bankruptcy Court. Under the termsof the Sealed Air settlement, subject to the fulfillment of certain conditions,Cryovac would make a payment of $512.5 million (plus interest at 5.5%compounded annually, commencing on December 21, 2002) and nine millionshares of Sealed Air common stock (collectively valued at $1,114.5 millionas of September 30, 2006), as directed by the Bankruptcy Court uponconfirmation of the Debtors’ plan of reorganization. In June 2005, the SealedAir settlement was approved by the Bankruptcy Court.

***Debt Capital***—All of the Debtors’pre-petition debt is in default due to the Filing. The accompanyingConsolidated Balance Sheets reflect the classification of the Debtors’pre-petition debt within “liabilities subject to compromise.”

The Debtors haveentered into a debtor-in-possession post-petition loan and security agreementwith Bank of America, N.A. (the “DIP facility”) in the aggregate amount of $250 million.  The term of the DIP facility expires on April 1,2008.

***Accounting Impact***—The accompanyingConsolidated Financial Statements have been prepared in accordance withStatement of Position 90-7 (“SOP 90-7”), “Financial Reporting by Entitiesin Reorganization Under the Bankruptcy Code,” promulgated by the AmericanInstitute of Certified Public Accountants. SOP 90-7 requires thatfinancial statements of debtors-in-possession be prepared on a going concernbasis, which contemplates continuity of operations, realization of assets andliquidation of liabilities in the ordinary course of business.  However, as a result of the Filing, therealization of certain of the Debtors’ assets and the liquidation of certain ofthe Debtors’ liabilities are subject to significant uncertainty. Whileoperating as debtors-in-possession, the Debtors may sell or otherwise disposeof assets and liquidate or settle liabilities for amounts other than thosereflected in the Consolidated Financial Statements. Further, the ultimate planof reorganization could materially change the amounts and classificationsreported in the Consolidated Financial Statements.

Pursuant to SOP 90-7,Grace’s pre-petition liabilities that are subject to compromise are required tobe reported separately on the balance sheet at an estimate of the amount thatwill ultimately be allowed by the Bankruptcy Court. As of September 30,2006, such pre-petition liabilities include fixed obligations (such as debt andcontractual commitments), as well as estimates of costs related to contingentliabilities (such as 

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asbestos-relatedlitigation, environmental remediation, and other claims). Obligations of Gracesubsidiaries not covered by the Filing continue to be classified on theConsolidated Balance Sheets based upon maturity dates or the expected dates of payment. SOP 90-7also requires separate reporting of certain expenses, realized gains andlosses, and provisions for losses related to the Filing as reorganizationitems.  Grace presents reorganizationitems as “Chapter 11 expenses, net,” a separate caption in its ConsolidatedStatements of Operations.

Grace has notrecorded the benefit of any assets that may be available to fundasbestos-related and other liabilities under the litigation settlements withSealed Air and Fresenius, as such agreements are subject to conditions which,although expected to be met, have not been satisfied and confirmed by theBankruptcy Court. The value available under these litigation settlementagreements as measured at September 30, 2006, was $1,229.5 millioncomprised of $115.0 million in cash from Fresenius and $1,114.5 millionin cash and stock from Cryovac. Payments under the Sealed Air settlement willbe made directly to the asbestos trust by Cryovac, and will be accounted for asa satisfaction of a portion of Grace’s recorded asbestos-related liability anda credit to shareholder’s equity.

**Grace’sConsolidated Balance Sheets separately identify the liabilities that are “subjectto compromise” as a result of the Chapter 11 proceedings. In Grace’s case,“liabilities subject to compromise” represent pre-petition liabilities asdetermined under U.S. generally accepted accounting principles. Changes to therecorded amount of such liabilities will be based on developments in the Chapter 11Cases and management’s assessment of the claim amounts that will ultimately beallowed by the Bankruptcy Court. Changes to pre-petition liabilities subsequentto the Filing Date reflect: 1) cash payments under approved court orders;2) the terms of Grace’s proposed plan of reorganization, as discussedabove, including the accrual of interest on pre-petition debt and other fixedobligations; 3) accruals for employee-related programs; and 4) changesin estimates related to other pre-petition contingent liabilities.**

Components ofliabilities subject to compromise are as follows:
| ***(In millions)***                     | ** ** | **September 30,  2006** | ** **  | **December 31,  2005** | ** ** |
|----------------------------------------------|------------|------------------------------|-------------|-----------------------------|------------|
| Debt,  pre-petition plus accrued interest    | ** ** | **$**                        | **725.3**   |                        | $          | 684.7 |   |
| Asbestos-related  liability                  | ** ** | **1,700.0**                  |        | 1,700.0                     |       |
| Income taxes                                 | ** ** | **133.7**                    |        | 136.5                       |       |
| Environmental  remediation                   | ** ** | **363.2**                    |        | 342.0                       |       |
| Postretirement  benefits other than pension  | ** ** | **86.4**                     |        | 101.3                       |       |
| Unfunded special  pension arrangements       | ** ** | **89.0**                     |        | 86.4                        |       |
| Retained  obligations of divested businesses | ** ** | **14.8**                     |        | 18.1                        |       |
| Accounts payable                             | ** ** | **31.7**                     |        | 31.5                        |       |
| Other accrued  liabilities                   | ** ** | **67.5**                     |        | 54.6                        |       |
| **Total Liabilities Subject to  Compromise** | ** ** | **$**                        | **3,211.6** |                        | $          | 3,155.1 |   |

 

Note that theunfunded special pension arrangements reflected above exclude non-U.S. plansand qualified U.S. plans that became underfunded subsequent to the Filing.Contributions to qualified U.S. plans are subject to Bankruptcy Court approval.

***Change in Liabilities Subject to Compromise***—Thefollowing chart is a reconciliation of the changes in pre-filing date liabilitybalances for the period from the Filing Date through September 30, 2006.
| ***(In millions)***                                                                            | ** ** | **Cumulative  Since Filing** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| Balance, Filing  Date April 2, 2001                                                            |       | $                                 | 2,366.0    |   |
| Cash  disbursements and/or reclassifications under Bankruptcy Court orders:                         |       |                              |       |
| Freight and distribution order                                                                      |       | (5.7                              | )          |
| Trade accounts payable order                                                                        |       | (9.1                              | )          |
| Settlements of noncore contingencies                                                                |       | (119.7                            | )          |
| Other court orders including employee wages and  benefits, sales and use tax, and customer programs |       | (325.2                            | )          |
| Expense/(income)  items:                                                                            |       |                              |       |
| Interest on pre-petition liabilities                                                                |       | 256.7                             |       |
| Employee-related accruals                                                                           |       | 36.7                              |       |
| Change in estimate of asbestos-related contingencies                                                |       | 744.8                             |       |
| Change in estimate of environmental contingencies                                                   |       | 295.6                             |       |
| Change in estimate of income tax contingencies                                                      |       | (2.8                              | )          |
| Balance sheet  reclassifications                                                                    |       | (25.7                             | )          |
| Balance, end of period                                                                              |       | $                                 | 3,211.6    |   |

 

Additionalliabilities subject to compromise may arise due to the rejection of executorycontracts or unexpired leases, or as a result of the Bankruptcy Court’sallowance of contingent or disputed claims.

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BeginningJanuary 1, 2006, Grace agreed to pay interest on pre-petition bank debt atthe prime rate quoted by Bloomberg, adjusted for periodic changes, andcompounded quarterly. The effective rates for the three months and nine monthsended September 30, 2006 were 8.25% and 7.86%, respectively.  From the Filing Date through December 31,2005, Grace accrued interest on pre-petition bank debt at a negotiated fixedannual rate of 6.09%, compounded quarterly.

***Chapter 11 Expenses***(In millions)
| ** **                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                         | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Legal and  financial advisory fees | ** ** | **$**                                                | **13.9**   |                                                | $          | 11.2 | ** ** | **$** | **38.1** |   | $ | 25.2 |   |
| Interest income                    | ** ** | **(1.9**                                             | **)**      | (1.9                                                | )          | **(5.9** | **)** | (5.3 | ) |
| Chapter 11  expenses, net     | ** ** | **$**                                                | **12.0**   |                                                | $          | 9.3 | ** ** | **$** | **32.2** |   | $ | 19.9 |   |

 

Pursuant to SOP 90-7,interest income earned on the Debtors’ cash balances must be offset against Chapter 11expenses.  Cumulative legal and financialadvisory fees since the Filing were $159.4 million through September 30,2006.

***Condensed Financial Information of the Debtors***

**W. R. Grace & Co.—Chapter 11 FilingEntitiesDebtor-in-PossessionStatements of Operations***(In millions)*
| ** **                                                                                                                                | ** ** | **Nine Months Ended  September 30,** | ** **  |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|-------------|
| ** **                                                                                                                                | ** ** | **2006**                                            | ** **  | **2005** | ** ** |
| Net sales,  including intercompany                                                                                                        | ** ** | **$**                                               | **1,096.7** |   | $ | 952.6 |   |
| Cost of goods  sold, including intercompany, exclusive of depreciation and amortization  shown separately below                           | ** ** | **810.1**                                           |        | 659.7 |   |
| Selling, general  and administrative expenses, exclusive of net pension expense and  depreciation and amortization shown separately below | ** ** | **265.0**                                           |        | 199.0 |   |
| Research and  development expenses                                                                                                        | ** ** | **30.3**                                            |        | 28.7 |   |
| Depreciation and  amortization                                                                                                            | ** ** | **44.6**                                            |        | 49.2 |   |
| Net pension  expense                                                                                                                      | ** ** | **34.8**                                            |        | 39.2 |   |
| Interest expense  and related financing costs                                                                                             | ** ** | **54.2**                                            |        | 40.8 |   |
| Provision for  environmental remediation                                                                                                  | ** ** | **30.0**                                            |        | — |   |
| Other (income)  expense                                                                                                                   | ** ** | **(48.7**                                           | **)**       | (65.5 | ) |
|                                                                                                                                      | ** ** | **1,220.3**                                         |        | 951.1 |   |
| Income (loss)  before Chapter 11 expenses, income taxes, and equity in net income of  non-filing entities                            | ** ** | **(123.6**                                          | **)**       | 1.5 |   |
| Chapter 11  expenses, net                                                                                                            | ** ** | **(32.1**                                           | **)**       | (19.7 | ) |
| Benefit from  (provision for) income taxes                                                                                                | ** ** | **35.2**                                            |        | 4.2 |   |
| Income (loss)  before equity in net income of non-filing entities                                                                         | ** ** | **(120.5**                                          | **)**       | (14.0 | ) |
| Equity in net  income of non-filing entities                                                                                              | ** ** | **133.8**                                           |        | 81.9 |   |
| **N****et income (loss)**                                                                                                                 | ** ** | **$**                                               | **13.3**    |   | $ | 67.9 |   |

 

 

I-14

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**W. R. Grace & Co.—Chapter 11 Filing EntitiesDebtor-in-PossessionCondensed Statements of Cash Flows***(In millions)*
| ** **                                                                                     | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                     | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| **Operating Activities**                                                                       | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Net income (loss)                                                                              | ** ** | **$**                                               | **13.3**   |   | $ | 67.9 |   |
| Reconciliation to net  cash provided by (used for) operating activities:                       |       |                                                |       |   |   |
| Chapter 11  expenses, net                                                                      | ** ** | **32.1**                                            |       | 19.7 |   |
| (Benefit from)  provision for income taxes                                                     | ** ** | **(35.2**                                           | **)**      | (4.2 | ) |
| Equity in net  income of non-filing entities                                                   | ** ** | **(133.8**                                          | **)**      | (81.9 | ) |
| Depreciation and  amortization                                                                 | ** ** | **44.6**                                            |       | 49.2 |   |
| Interest on  pre-petition liabilities subject to compromise                                    | ** ** | **53.1**                                            |       | 37.7 |   |
| Provision for  environmental remediation                                                       | ** ** | **30.0**                                            |       | — |   |
| Other non-cash  items, net                                                                     | ** ** | **0.4**                                             |       | (1.6 | ) |
| Contributions to  defined benefit pension plans                                                | ** ** | **(99.2**                                           | **)**      | (24.9 | ) |
| Cash paid to  settle noncore contingencies                                                     | ** ** | **—**                                          |       | (119.7 | ) |
| Changes in other  assets and liabilities, excluding the effect of businesses acquired/divested | ** ** | **(16.5**                                           | **)**      | (49.1 | ) |
| **Net cash provided by (used for)  operating activities**                                      | ** ** | **(111.2**                                          | **)**      | (106.9 | ) |
| **Investing Activities**                                                                       | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| Capital expenditures                                                                           | ** ** | **(60.2**                                           | **)**      | (37.8 | ) |
| Loan repayments and  other                                                                     | ** ** | **80.9**                                            |       | 81.0 |   |
| **Net cash provided by (used for)  investing activities**                                      | ** ** | **20.7**                                            |       | 43.2 |   |
| **Net cash provided by (used for)  financing activities**                                      | ** ** | **(1.8**                                            | **)**      | (2.1 | ) |
| **Net increase (decrease) in cash  and cash equivalents**                                      | ** ** | **(92.3**                                           | **)**      | (65.8 | ) |
| Cash and cash  equivalents, beginning of period                                                | ** ** | **269.2**                                           |       | 340.0 |   |
| Cash and cash equivalents, end of period                                                       | ** ** | **$**                                               | **176.9**  |   | $ | 274.2 |   |

 

**W. R. Grace & Co.—Chapter 11Filing EntitiesDebtor-in-Possession Balance Sheets***(In millions)*

 
| *** ***                                                   | ** ** | ** **  | ** **  | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------|------------|-------------|-------------|------------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                     | ** ** | ** **  | ** **  | ** **                   | ** ** |
| **Current  Assets**                                            | ** ** | ** **  | ** **  | ** **                   | ** ** |
| Cash and cash  equivalents                                     | ** ** | **$**       | **176.9**   |                         | $          | 269.2                       |       |
| Trade accounts  receivable, net                                | ** ** | **139.4**   |        | 108.0                        |       |
| Receivables from  non-filing entities, net                     | ** ** | **61.3**    |        | 62.3                         |       |
| Inventories                                                    | ** ** | **73.2**    |        | 86.8                         |       |
| Other current  assets                                          | ** ** | **43.8**    |        | 53.5                         |       |
| **Total  Current Assets**                                      | ** ** | **494.6**   |        | 579.8                        |       |
| Properties and  equipment, net                                 | ** ** | **392.1**   |        | 378.9                        |       |
| Cash value of  life insurance policies, net of policy loans    | ** ** | **86.9**    |        | 84.8                         |       |
| Deferred income  taxes                                         | ** ** | **734.2**   |        | 701.0                        |       |
| Asbestos-related  insurance                                    | ** ** | **500.0**   |        | 500.0                        |       |
| Loans receivable  from non-filing entities, net                | ** ** | **255.4**   |        | 306.9                        |       |
| Investment in  non-filing entities                             | ** ** | **703.2**   |        | 527.9                        |       |
| Other assets                                                   | ** ** | **77.7**    |        | 79.3                         |       |
| **Total  Assets**                                              | ** ** | **$**       | **3,244.1** |                         | $          | 3,158.6                     |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY (DEFICIT)**       | ** ** | ** **  | ** **  | ** **                   | ** ** |
| **Liabilities  Not Subject to Compromise**                     | ** ** | ** **  | ** **  | ** **                   | ** ** |
| Current  liabilities                                           | ** ** | **$**       | **207.4**   |                         | $          | 187.3                       |       |
| Minority  interest in consolidated affiliates                  | ** ** | **57.1**    |        | 32.6                         |       |
| Other  liabilities                                             | ** ** | **312.1**   |        | 378.9                        |       |
| **Total  Liabilities Not Subject to Compromise**               | ** ** | **576.6**   |        | 598.8                        |       |
| **Liabilities  Subject to Compromise**                         | ** ** | **3,211.6** |        | 3,155.1                      |       |
| **Total  Liabilities**                                         | ** ** | **3,788.2** |        | 3,753.9                      |       |
| **Shareholders’  Equity (Deficit)**                       | ** ** | **(544.1**  | **)**       | (595.3                       | )          |
| **Total Liabilities and  Shareholders’ Equity (Deficit)** | ** ** | **$**       | **3,244.1** |                         | $          | 3,158.6                     |       |

 

In addition to Grace’sfinancial reporting obligations as prescribed by the U.S. Securities andExchange Commission, the Debtors are also required, under the rules andregulations of the Bankruptcy Code, to periodically file certain statements andschedules and a monthly operating report with the Bankruptcy Court. Thisinformation is available to the public through the Bankruptcy Court. Thisinformation is prepared in a format that may not be comparable to informationin Grace’s quarterly and annual financial statements as filed with the SEC. Themonthly operating reports are not audited, do not purport to represent thefinancial position or results of operations of Grace on a consolidated basis,and should not be relied on for such purposes.

I-15

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** **
| **3.** | ** ** | **Asbestos-Related Litigation** |
|--------|------------|---------------------------------|

 

Grace is adefendant in property damage and personal injury lawsuits relating topreviously sold asbestos-containing products. As of the Filing Date, Grace wasa defendant in 65,656 asbestos-related lawsuits, 17 involving claims for propertydamage (one of which has since been dismissed), and the remainder involving129,191 claims for personal injury. Due to the Filing, holders ofasbestos-related claims are stayed from continuing to prosecute pendinglitigation and from commencing new lawsuits against the Debtors. Separatecreditors’ committees representing the interests of property damage andpersonal injury claimants, and a legal representative of future personal injuryclaimants, have been appointed in the Chapter 11 Cases. Grace’s obligationswith respect to present and future claims will be determined through theChapter 11 process.

***Property Damage Litigation***—Theplaintiffs in asbestos property damage lawsuits generally seek to have thedefendants pay for the cost of removing, containing or repairing theasbestos-containing materials in the affected buildings. Each property damagecase is unique in that the age, type, size and use of the building, and thedifficulty of asbestos abatement, if necessary, vary from structure to structure.Information regarding product identification, the amount of product in thebuilding, the age, type, size and use of the building, the legal status of theclaimant, the jurisdictional history of prior cases and the court in which thecase is pending has provided meaningful guidance as to the range of potentialcosts.

Out of 380asbestos property damage cases (which involved thousands of buildings) filedprior to the Filing Date, 140 were dismissed without payment of any damages orsettlement amounts; judgments after trial were entered in favor of Grace innine cases (excluding cases settled following appeals of judgments in favor ofGrace); judgments after trial were entered in favor of the plaintiffs in eightcases (one of which is on appeal) for a total of $86.1 million; 207 propertydamage cases were settled for a total of $696.8 million; and 16 cases remainoutstanding (including the one on appeal). Of the 16 remaining cases, eightrelate to ZAI and eight relate to a number of former asbestos-containing products(two of which also are alleged to involve ZAI).

Approximately 4,300additional property damage claims were filed prior to the March 31, 2003 claimsbar date established by the Bankruptcy Court. (The bar date did not apply toZAI claims.) Such claims were reviewed in detail by Grace, categorized intoclaims with sufficient information to be evaluated or claims that requireadditional information and, where sufficient information existed, the estimatedcost of resolution was considered as part of Grace’s recorded asbestos-relatedliability. (Approximately 200 claims did not contain sufficient information topermit an evaluation.) Grace has objected to virtually all property damageclaims on a number of different bases, including: no authorization to file aclaim; the claim was previously settled or adjudicated; no or insufficientdocumentation; failure to identify a Grace product; the expiration of theapplicable statute of limitations and/or statute of repose, and/or laches; anda defense that the product in place is not hazardous. As of October 31, 2006,following the reclassification, withdrawal or expungement of claims,approximately 640 property damage claims remain outstanding.

Eight of the ZAI caseswere filed as purported class action lawsuits in 2000 and 2001. In addition,ten lawsuits were filed as purported class actions in 2004 and 2005 withrespect to persons and homes in Canada. These cases seek damages and equitablerelief, including the removal, replacement and/or disposal of all such insulation.The plaintiffs assert that this product is in millions of homes and that thecost of removal could be several thousand dollars per home. As a result of theFiling, the eight U.S. cases have been transferred to the Bankruptcy Court.  Based on Grace’s investigation of the claimsdescribed in these lawsuits, and testing and analysis of this product by Graceand others, Grace believes that the product was and continues to be safe forits intended purpose and poses little or no threat to human health. Theplaintiffs in the ZAI lawsuits (and the U.S. government in the Montana criminalproceeding described in Note 12) dispute Grace’s position on the safety of ZAI.In July 2002, the Bankruptcy Court approved special counsel to represent, atthe Debtors’ expense, the ZAI claimants in a proceeding to determine certainthreshold scientific issues regarding ZAI. On October 18, 2004, the BankruptcyCourt held a hearing on motions filed by the parties to address a number ofimportant legal and factual issues regarding the ZAI claims, and has taken themotions under advisement. No decision has yet been rendered.  Grace’s recorded asbestos-related liabilityat September 30, 2006 assumes the risk of loss from ZAI litigation is notprobable.  If Grace’s view as to risk ofloss were not 

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sustained, managementbelieves the cost to resolve the matter would be material.

***Personal Injury Litigation***—Asbestospersonal injury claimants allege adverse health effects from exposure toasbestos-containing products formerly manufactured by Grace. Claims aregenerally similar to each other, differing primarily in the type ofasbestos-related illness allegedly suffered by the plaintiff. Grace’s cost toresolve such claims has been influenced by numerous variables, including thesolvency of other former producers of asbestos containing products,cross-claims by co-defendants, the rate at which new claims are filed, thejurisdiction in which the claims are filed, and the defense and dispositioncosts associated with these claims.

Cumulatively through theFiling Date, 16,354 asbestos personal injury lawsuits involving approximately35,720 claims were dismissed without payment of any damages or settlementamounts (primarily on the basis that Grace products were not involved) andapproximately 55,489 lawsuits involving approximately 163,698 claims weredisposed of (through settlements and judgments) for a total of $645.6million.  As of the Filing Date, 129,191claims for personal injury were pending against Grace. Grace believes that asubstantial number of additional personal injury claims would have beenreceived between the Filing Date and September 30, 2006 had such claims notbeen stayed by the Bankruptcy Court.

***Asbestos-Related Liability***—The total recorded asbestos-related liabilitybalance as of September 30, 2006 and December 31, 2005 was $1,700.0 million andis included in “liabilities subject to compromise” in the accompanyingConsolidated Balance Sheets.  Graceadjusted its asbestos-related liability in the fourth quarter of 2004 based onits proposed plan of reorganization as discussed in Note 2. The amount recordedat September 30, 2006 includes the $1,613 million maximum amount reflected as acondition precedent to the Plan and $87 million related to pre-Chapter 11contractual settlements and judgments included in general unsecured claims.

Under the Plan,Grace is requesting that the Bankruptcy Court determine the aggregate dollaramount, on a net present value basis, that must be funded on the effective dateof the Plan into an asbestos trust (established under Section 524(g) of theBankruptcy Code) to pay all allowed pending and future asbestos-relatedpersonal injury and property damage claims (including ZAI) and related trustadministration costs and expenses on the later of the effective date of thePlan or when allowed (the “Funding Amount”). It is a condition to confirmationof the Plan that the Bankruptcy Court shall conclude that the Funding Amount isnot greater than $1,613 million. This amount, which should be sufficient to fundover $2 billion in pending and future claims, is based in part on Grace’sevaluation of (1) existing but unresolved personal injury and property damageclaims, (2) actuarially-based estimates of future personal injury claims, (3)the risk of loss from ZAI litigation, (4) proposed claim payments reflected inthe Plan, and (5) the cost of the trust administration and litigation. Thisamount may not be consistent with what the Bankruptcy Court may conclude wouldbe a sufficient Funding Amount.

The BankruptcyCourt has entered separate case management orders for estimating liability forpending and future personal injury claims and adjudicating pending propertydamage claims, excluding ZAI claims. The Debtors expect that the estimatedliability will provide the basis for determining the Funding Amount to be paidinto the trust on the effective date of the Plan.

For personalinjury claims, the Bankruptcy Court has ordered that all claimants with claimspending as of the Filing Date (other than settled but unpaid claims) mustcomplete detailed questionnaires providing information on, among other things,their medical condition, including diagnostic support, exposure to Grace andnon-Grace asbestos-containing products, employment history, and pendinglawsuits against other companies.

Approximately60,000 questionnaires were returned in response to the July 12, 2006deadline.  Grace has analyzed thequestionnaires and believes that a substantial percentage of the submittedquestionnaires provide insufficient or incomplete responses.  In response to a request by Grace to compelthe asbestos personal injury claimants to cure these deficiencies, theBankruptcy Court has issued a ruling clarifying the information required ofclaimants submitting questionnaire responses and allowing claimants additionaltime to supplement their responses.

In August 2006,the Bankruptcy Court established bar dates for filing asbestos personal injuryclaims pending as of the Filing Date. Claimants asserting settled but unpaid pre-petition personal injuryclaims were required to file proofs of claim by 

I-17

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October 16,2006.  Approximately 35,000 of suchclaims were submitted.  Non-settledpre-petition personal injury proofs of claim must be filed by November 15,2006.

Grace expects the estimationprocess for personal injury claims will include the compilation of data fromthe questionnaires, review and analysis of such data by experts, thepreparation of expert reports, including estimates of the number of personalinjury claims expected to be filed in the future, and depositions of witnessesand other pretrial discovery proceedings. Grace expects the process to concludein an estimation hearing in mid-2007.

For propertydamage claims, the case management order provides that estimation will be precededby litigation on certain common threshold issues affecting a substantialmajority of claims. Such litigation will consist of determining, among otherthings, (1) whether asbestos-containing products formerly manufactured by Graceare hazardous in place, (2) the date by****whichbuilding owners knew or should have known of the reported hazards ofasbestos-containing materials****intheir buildings, which would provide the basis for a statute of limitationsdefense, and (3) the evidentiary admissibility of certain asbestos testingmethodologies. During the period preceding the estimation hearing, Grace willalso ask****the Bankruptcy Court torule on Grace’s specific objections to individual claims and groups of claims.Claims not resolved or expunged through the common issue litigation or theobjection process are expected to be the subject of an estimation hearing thatis currently scheduled to take place during the second quarter of 2007.

The Funding Amount willbe primarily a function of the number of estimated allowed property damage andpersonal injury claims, and the amount payable per claim. Through theestimation process, Grace will seek to demonstrate that most claims have novalue because they fail to establish any material property damage, health impairmentor significant occupational exposure to asbestos from Grace’s operations orproducts. If the Bankruptcy Court agrees with Grace’s position on the numberof, and the amounts to be paid in respect of, allowed personal injury andproperty damage claims, then Grace believes that the Funding Amount could beless than $1,613 million. However, this outcome is highly uncertain and willdepend on a number of Bankruptcy Court rulings favorable to Grace’s position.

Conversely, theasbestos claimants committees and the representative of future asbestosclaimants continue to assert that Grace’s asbestos-related liabilities aresubstantially higher than $1,613 million, and in fact are in excess of Grace’sbusiness value.  If the Court accepts theposition of the asbestos claimants committees, then any plan of reorganizationlikely would result in the loss of all or substantially all equity value bycurrent shareholders. Therefore, due to the significant uncertainties of thisprocess and asbestos litigation generally, Grace is not able to estimate aprobable Funding Amount that would be accepted by the Bankruptcy Court.

However, as Graceis willing to proceed with confirmation of the Plan with a Funding Amount of upto $1,613 million (assuming that other conditions precedent to confirmation ofthe Plan are satisfied, including the availability of the payment from Cryovacdirectly to the asbestos trust under the settlement agreement described in Note2), during the fourth quarter of 2004, Grace accrued a charge of $714.8 millionto increase its recorded asbestos-related liability to reflect the maximumamount allowed as a condition precedent under the Plan. This amount, plus $87.0million for pre-Chapter 11 contractual settlements and judgments, brings thetotal recorded asbestos-related liability as of September 30, 2006 and December31, 2005 to $1,700 million. Any differences between the Plan as filed and asapproved for confirmation could fundamentally change the accounting measurementof Grace’s asbestos-related liability and that change could be material.

***Insurance Rights***—Grace previouslypurchased insurance policies that provide coverage for years 1962 to 1985 withrespect to asbestos-related lawsuits and claims. Since 1985, insurance coveragefor asbestos-related liabilities has not been commercially available to Grace.

With one exception, coverage disputes regarding Grace’s primaryinsurance policies have been settled, and the settlement amounts paid in full.Grace’s excess coverage is for loss above certain levels.  The levels vary from policy to policy,creating “layers” of excess coverage, some of which are triggered beforeothers. As of September 30, 2006, after subtracting previous reimbursements byinsurers and allowing for discounts pursuant to certain settlement agreements,there remains approximately $959 million of excess coverage from approximately54 presently solvent insurers.

I-18

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Grace has entered into settlement agreements with various excessinsurance carriers. These settlements involve amounts paid and to be paid toGrace. The unpaid maximum aggregate amount for settled insurers available underthese settlement agreements is approximately $476 million.  With respect to asbestos-related personalinjury claims, the settlement agreements generally require that the claims bespread over the claimant’s exposure period and that each insurer pay a pro rataportion of each claim based on the amount of coverage provided during each yearof the total exposure period.

Presently, Grace has no agreements in place with insurers withrespect to approximately $483 million of excess coverage, which is atlayers of coverage that have not yet been triggered, but certain layers wouldbe triggered if the Plan were approved at the recorded asbestos-related liabilityof $1,700 million. Grace believes that any allowed ZAI claims also would becovered under the settlement agreements and unsettled policies discussed aboveto the extent they relate to installations of ZAI occurring after July 1,1973.

In addition to the approximately $959 million of excess coveragewith solvent insurers, Grace has approximately $318 million of excesscoverage with insolvent or non-paying insurance carriers. Non-paying carriersare those that, although technically solvent, are not currently meeting theirobligations to pay claims. Grace has filed and continues to file claims in theinsolvency proceedings of insolvent carriers. Grace is currently receivingdistributions from some of these insolvent carriers and expects to receivedistributions in the future. Settlement amounts are recorded as income whenreceived.

Grace estimatesthat, assuming an ultimate payout of asbestos-related claims equal to therecorded liability of $1,700 million, it should be entitled to approximately$500 million, on a net present value basis, of insurance recovery.
| **4.** | ** ** | **Acquisitions and Joint Ventures** |
|--------|------------|-------------------------------------|

# ** **

In June 2006,Grace acquired the custom catalyst manufacturing assets of Basell, USA, as wellas Basell’s components business for cash consideration of $20.0 million.  The manufacturing assets and the results ofoperations of the acquired business have been included as part of the GraceDavison operating segment since the date of acquisition.

During the first nine months of 2005, Grace completedtwo acquisitions for a total cash cost of $2.5 million as follows:

·                  InFebruary 2005, Grace acquired certain assets of Midland Dexter Venezuela, S.A.(“Midevensa”). Midevensa supplies coatings and sealants for rigid packaging inthe local and export markets of Latin America.

·                  InMarch 2005, Grace acquired certain assets relating to the concrete admixturesbusiness of Perstorp Peramin AB (“Perstorp”) located in Sweden. Perstorpsupplies specialty chemicals and materials to the construction industry inSweden and other Northern European countries.
| **5.** | ** ** | **Other  (Income) Expense** |
|--------|------------|-----------------------------|

 

Components ofother (income) expense are as follows:

** **

 
| **Other (Income)  Expense**

***(In millions)***            | ** ** | **Three Months  Ended  September 30,** | ** ** | **Nine Months  Ended  September 30,** | ** ** |
|------------------------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                       | ** ** | **2006**                                         | ** ** | **2005**                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Income from  insurance settlements                               | ** ** | **$**                                            | **(0.9**   | **)**                                           | $          | (4.2 | ) | **$** | **(7.8** | **)** | $ | (24.5 | ) |
| COLI income, net                                                 | ** ** | **(0.5**                                         | **)**      | 0.3                                             | ** ** | **(2.2** | **)** | (1.6 | ) |
| Interest income                                                  | ** ** | **(1.7**                                         | **)**      | (0.8                                            | )          | **(4.7** | **)** | (2.4 | ) |
| Net (gain) loss  on sales of investments and disposals of assets | ** ** | **0.2**                                          |       | 1.4                                             | ** ** | **(2.6** | **)** | 0.9 |   |
| Currency  translation—intercompany loan                     | ** ** | **(2.4**                                         | **)**      | 1.1                                             | ** ** | **(16.1** | **)** | 32.5 |   |
| Value of  currency contracts                                     | ** ** | **1.6**                                          |       | (1.1                                            | )          | **15.1** |   | (32.3 | ) |
| Other currency  transaction effects                              | ** ** | **(0.2**                                         | **)**      | 0.3                                             | ** ** | **2.5** |   | 0.8 |   |
| Other  miscellaneous income                                      | ** ** | **(2.4**                                         | **)**      | (1.4                                            | )          | **(6.3** | **)** | (7.8 | ) |
| Total other (income)  expense                                    | ** ** | **$**                                            | **(6.3**   | **)**                                           | $          | (4.4 | ) | **$** | **(22.1** | **)** | $ | (34.4 | ) |

 

Grace accounts forcurrency fluctuations on an intercompany loan between its subsidiaries in theUnited States and Germany as a component of operating results instead of as acomponent of other comprehensive income because Grace has determined that theloan is not part of its permanent capital structure in Germany.

 

I-19

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**6.   OtherBalance Sheet Accounts**
| ***(In millions)***                                                     | ** ** | ** ** | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------------------------------------------------|------------|------------|------------|------------------------------|------------|-----------------------------|------------|
| **Inventories**                                                              | ** ** | ** ** | ** ** | ** **                   | ** ** |
| Raw materials                                                                | ** ** | **$**      | **67.1**   |                         | $          | 67.3                        |       |
| In process                                                                   | ** ** | **40.0**   |       | 32.8                         |       |
| Finished products                                                            | ** ** | **189.7**  |       | 210.8                        |       |
| General merchandise                                                          | ** ** | **33.0**   |       | 33.2                         |       |
| Less: Adjustment of certain inventories to a  last-in/first-out (LIFO) basis | ** ** | **(42.4**  | **)**      | (65.8                        | )          |
|                                                                         | ** ** | **$**      | **287.4**  |                         | $          | 278.3                       |       |
| **Other Assets**                                                             |       |       |       |                         |       |
| Deferred pension costs                                                       | ** ** | **$**      | **119.6**  |                         | $          | 108.8                       |       |
| Deferred charges                                                             | ** ** | **11.9**   |       | 20.8                         |       |
| Long-term receivables, less allowances of $0.8 (2005–$0.7)              | ** ** | **7.4**    |       | 7.6                          |       |
| Patents, licenses and other intangible assets, net                           | ** ** | **86.4**   |       | 87.6                         |       |
| Pension-unamortized prior service cost                                       | ** ** | **12.7**   |       | 12.7                         |       |
| Investments in unconsolidated affiliates and other                           | ** ** | **0.6**    |       | 0.6                          |       |
|                                                                         | ** ** | **$**      | **238.6**  |                         | $          | 238.1                       |       |
| **Other Current Liabilities**                                                | ** ** | ** ** | ** ** | ** **                   | ** ** |
| Accrued compensation                                                         | ** ** | **$**      | **82.0**   |                         | $          | 70.4                        |       |
| Deferred tax liability                                                       | ** ** | **0.9**    |       | 0.8                          |       |
| Customer volume rebates                                                      | ** ** | **36.2**   |       | 35.4                         |       |
| Accrued commissions                                                          | ** ** | **12.7**   |       | 11.1                         |       |
| Accrued reorganization fees                                                  | ** ** | **23.8**   |       | 18.0                         |       |
| Other accrued liabilities                                                    | ** ** | **66.8**   |       | 62.2                         |       |
|                                                                         | ** ** | **$**      | **222.4**  |                         | $          | 197.9                       |       |

 

During the third quarter of 2006, a reduction in U.S.LIFO inventory levels resulted in costs pertaining to prior years beingreflected in cost of sales for the three months ended September 30, 2006.  This had the effect of increasing pre-tax incomeby $1.3 million compared to current cost.

Accrued compensation in the table above includes salariesand wages as well as estimated amounts due under the annual and long-termincentive programs. Other liabilities in the Consolidated Balance Sheetincludes amounts expected to be paid under these programs after October 1,2007.

**7.   LifeInsurance**

Graceis the beneficiary of corporate-owned life insurance (“COLI”) policies oncertain current and former employees with a net cash surrender value of $86.9million and $84.8 million at September 30, 2006 and December 31, 2005,respectively. The policies were acquired to fund various employee benefitprograms and other long-term liabilities and are structured to provide cashflow (primarily tax-free) over an extended number of years.

The followingtables summarize activity in these policies for the nine months ended September30, 2006 and 2005, and the components of net cash value at September 30, 2006and December 31, 2005:

** **
| **Life Insurance—Activity Summary**    | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ***(In millions)***                              | ** ** | ** **                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Earnings on policy assets                             | ** ** | **$**                                               | **3.2**    |   | $ | 4.1 |   |
| Interest on policy  loans                             | ** ** | **(1.0**                                            | **)**      | (2.5 | ) |
| Premiums                                              | ** ** | **—**                                          |       | 1.8 |   |
| Policy loan repayments                                | ** ** | **0.1**                                             |       | 0.5 |   |
| Proceeds from  termination of life insurance policies | ** ** | **—**                                          |       | (14.8 | ) |
| Net investing activity                                | ** ** | **(0.2**                                            | **)**      | (2.2 | ) |
| Change in net cash  value                             | ** ** | **$**                                               | **2.1**    |   | $ | (13.1 | ) |
| Tax-free proceeds received                            | ** ** | **$**                                               | **0.4**    |   | $ | 2.2 |   |
|                                                       |            |                                                     |            |  |  |  |  |  |  |

 

** **
| **Components of Net Cash  Value**

***(In millions)*** | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Gross cash value                                                           | ** ** | **$**                        | **112.0**  |                        | $          | 109.2 |   |
| Principal—policy loans                                                | ** ** | **(23.6**                    | **)**      | (23.7                       | )          |
| Accrued interest—policy  loans                                        | ** ** | **(1.5**                     | **)**      | (0.7                        | )          |
| Net cash value                                                             | ** ** | **$**                        | **86.9**   |                        | $          | 84.8 |   |
| Insurance benefits in force                                                | ** ** | **$**                        | **196.9**  |                        | $          | 196.3 |   |

 

Grace’s financialstatements display income statement activity and balance sheet amounts on a netbasis, reflecting the contractual interdependency of policy assets andliabilities.

In January 2005,Grace surrendered and terminated most of its other COLI policies and receivedapproximately $14.8 million of net cash value from the termination.

 

** **

** **

**8.   Debt**

*** ***
| **Components of Debt**

***(In millions)*** | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **Debt payable within one year**                           | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Other short-term  borrowings                               | ** ** | **$**                        | **3.2**    |                        | $          | 2.3 |   |
| **Debt payable after one year**                            | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Other long-term  borrowings                                | ** ** | **$**                        | **0.4**    |                        | $          | 0.4 |   |
| **Debt Subject to Compromise**                             |       |                         |       |                        |       |
| Bank borrowings                                            | ** ** | **$**                        | **500.0**  |                        | $          | 500.0 |   |
| Other borrowings                                           | ** ** | **14.4**                     |       | 14.3                        |       |
| Accrued interest                                           | ** ** | **210.9**                    |       | 170.4                       |       |
|                                                       | ** ** | **$**                        | **725.3**  |                        | $          | 684.7 |   |
| Annualized weighted average interest rates on total  debt  | ** ** | **7.9**                      | **%**      | 6.1                         | %          |

 

In April 2001, theDebtors entered into the DIP facility for a two-year term in the aggregateamount

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of $250 million.The DIP facility is secured by a priority lien on substantially all assets ofthe Debtors with the exclusion of foreign stock holdings, and bears interestbased on the London Interbank Offered Rate (LIBOR). The Debtors have extendedthe term of the DIP facility through April 1, 2008. Grace had no outstandingborrowings under the DIP facility as of September 30, 2006; however, $48.7million of standby letters of credit were issued and outstanding under thefacility. The letters of credit, which reduce available funds under thefacility, were issued primarily for trade-related matters such as performancebonds, and certain insurance and environmental matters.

**9.   Shareholders’Equity (Deficit)**

Under itsCertificate of Incorporation, the Company is authorized to issue 300,000,000shares of common stock, $0.01 par value. Of the common stock unissued atSeptember 30, 2006, approximately 5,251,838 shares were reserved for issuancepursuant to stock options and other stock incentives. Since the Filing Date,Grace has not granted any stock options.

For additionalinformation, see Notes 15 and 17 to the Consolidated Financial Statements inGrace’s 2005 Form 10-K.

**10.   Earnings(Loss) Per Share**

The followingtable shows a reconciliation of the numerators and denominators used incalculating basic and diluted earnings (loss) per share.
| **Earnings (Loss) Per Share**                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ***(In millions, except per share amounts)*** | ** ** | **2006**                                             |       | **2005**                                            | ** ** | **2006** |   | **2005** | ** ** |
| **Numerators**                                                         | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss)                                                      | ** ** | **$**                                                | **18.4**   |                                                | $          | 32.1 | ** ** | **$** | **13.3** |   | $ | 67.9 |   |
| **Denominators**                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Weighted average common shares— basic calculation                 | ** ** | **68.3**                                             |       | 66.9                                                | ** ** | **67.7** |   | 66.8 |   |
| Dilutive effect of employee stock options                              | ** ** | **0.2**                                              |       | 0.3                                                 | ** ** | **0.4** |   | 0.5 |   |
| Weighted average common shares—diluted calculation                | ** ** | **68.5**                                             |       | 67.2                                                | ** ** | **68.1** |   | 67.3 |   |
| **Basic  earnings (loss) per share**                                   | ** ** | **$**                                                | **0.27**   |                                                | $          | 0.48 | ** ** | **$** | **0.20** |   | $ | 1.02 |   |
| **Diluted earnings (loss) per  share**                                 | ** ** | **$**                                                | **0.27**   |                                                | $          | 0.48 | ** ** | **$** | **0.20** |   | $ | 1.01 |   |

 

Excluded from the calculation of diluted earnings(loss) per share were currently outstanding options to purchase 4,677,325 and4,673,728 shares for the three and nine months ended September 30, 2006,respectively, and 6,397,833 shares for each of the three and nine months endedSeptember 30, 2005, because such shares would have been antidilutive.

**11.   Comprehensive Income (Loss)**

The tables belowpresent the pre-tax, tax and after tax components of Grace’s othercomprehensive income (loss) for the three months and nine months endedSeptember 30, 2006 and 2005:
| **Three Months  Ended September 30, 2006**

***(In millions)*** | ** ** | **Pre-Tax  Amount** | ** ** | **Tax  Expense** | ** ** | **After-  Tax  Amount** | ** ** |
|-------------------------------------------------------------------------------------|------------|---------------------|------------|------------------|------------|-------------------------|------------|
| Commodity  hedging activities                                                       |       | $                   | (0.6       | )                | $          | 0.2                     | ** ** | **$** | **(0.4** | **)** |
| Foreign currency  translation adjustments                                           |       | 8.3                 |       | —           | ** ** | **8.3**                 | ** ** |
| Other  comprehensive income (loss)                                                  |       | $                   | 7.7        |             | $          | 0.2                     | ** ** | **$** | **7.9** | ** ** |

 
| **Nine months Ended September 30, 2006**

***(In millions)*** | ** ** | **Pre-Tax  Amount** | ** ** | **Tax  Benefit** | ** ** | **After-  Tax  Amount** | ** ** |
|----------------------------------------------------------------------------------------|------------|---------------------|------------|------------------|------------|-------------------------|------------|
| Commodity  hedging activities                                                          |       | $                   | (1.0       | )                | $          | 0.3                     | ** ** | **$** | **(0.7** | **)** |
| Foreign currency  translation adjustments                                              |       | 22.9                |       | —           | ** ** | **22.9**                | ** ** |
| Other comprehensive  income (loss)                                                     |       | $                   | 21.9       |             | $          | 0.3                     | ** ** | **$** | **22.2** | ** ** |

 
| **Three Months Ended  September 30, 2005**

***(In millions)*** | ** ** | **Pre-Tax  Amount** | ** ** | **Tax  Benefit** | ** ** | **After-  Tax  Amount** | ** ** |
|------------------------------------------------------------------------------------------|------------|---------------------|------------|------------------|------------|-------------------------|------------|
| Foreign currency  translation adjustments                                                |       | $                   | (0.9       | )                | $          | —                  |       | $ | (0.9 | ) |
| Other comprehensive  income (loss)                                                       |       | $                   | (0.9       | )                | $          | —                  |       | $ | (0.9 | ) |

 
| **Nine months Ended September 30, 2005**

***(In millions)*** | ** ** | **Pre-Tax  Amount** | ** ** | **Tax  Benefit** | ** ** | **After-  Tax  Amount** | ** ** |
|----------------------------------------------------------------------------------------|------------|---------------------|------------|------------------|------------|-------------------------|------------|
| Foreign currency  translation adjustments                                              |       | $                   | (23.3      | )                | $          | —                  |       | $ | (23.3 | ) |
| Other comprehensive  income (loss)                                                     |       | $                   | (23.3      | )                | $          | —                  |       | $ | (23.3 | ) |

 

From time to time,Grace enters into derivatives such as forward contracts or option contractsdirectly with natural gas suppliers, and fixed-rate swaps with financialinstitutions to mitigate the risk of volatility of natural gas prices in theUnited States.  Under fixed-rate swaps,Grace locks in a fixed rate with a financial institution for future natural gaspurchases, purchases its natural gas from a supplier at the prevailing marketrate, and settles with the bank for any difference in the rates, thereby “swapping”a variable rate for a fixed rate.  Duringthe first nine months of 2006, Grace purchased forward contracts, swaps andoptions for

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a portion of itsexpected natural gas requirements. The outstanding swaps and options weretreated as effective cash flow hedges for accounting purposes and revalued atthe end of each of the first three quarters of 2006, with correspondingadjustments to other comprehensive income (loss).

The followingtable presents the components of Grace’s accumulated other comprehensive income(loss) at September 30, 2006 and December 31, 2005:

** **
| **Components of  Accumulated Other Comprehensive Income (Loss)**

***(In millions)*** | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Commodity  hedging (net of tax)                                                                 | ** ** | **$**                        | **(0.7**   | **)**                       | $          | — |   |
| Minimum pension  liability (net of tax)                                                         | ** ** | **(362.7**                   | **)**      | (362.7                      | )          |
| Foreign currency  translation                                                                   | ** ** | **(8.3**                     | **)**      | (31.2                       | )          |
| Accumulated other  comprehensive income (loss)                                                  | ** ** | **$**                        | **(371.7** | **)**                       | $          | (393.9 | ) |

 

Grace is a globalenterprise, which operates in over 40 countries with local currency generallydeemed to be the functional currency for accounting purposes. The foreigncurrency translation amount represents the adjustments necessary to translatethe balance sheets valued in local currencies to the U.S. dollar as of the endof each period presented, and to translate revenues and expenses at averageexchange rates for each period presented.

The decline inequity market returns in 2000-2002, coupled with a decline in interest ratesfrom 2000-2004, as well as updated assumptions for expected life-spans and thelongevity of Grace’s active work force, created a shortfall between theaccounting measurement of Grace’s obligations under certain of its qualifiedpension plans for U.S. employees and the market value of dedicated pensionassets. This condition required Grace to record a minimum pension liability forthese plans equal to the funding shortfall and to offset related deferred costsagainst shareholders’ equity (deficit) at December 31, 2005.

**12.   Commitmentsand Contingent Liabilities**

***Asbestos-Related Litigation*—See Note 3**

***Environmental Remediation*—**Grace issubject to loss contingencies resulting from extensive and evolving federal,state, local and foreign environmental laws and regulations relating to thegeneration, storage, handling, discharge and disposition of hazardous wastesand other materials. Grace accrues for anticipated costs associated withinvestigative and remediation efforts where an assessment has indicated that aprobable liability has been incurred and the cost can be reasonably estimated.These accruals do not take into account any discounting for the time value ofmoney.

Grace’senvironmental liabilities are reassessed whenever circumstances become betterdefined or remediation efforts and their costs can be better estimated. Theseliabilities are evaluated based on currently available information, includingthe progress of remedial investigation at each site, the current status ofdiscussions with regulatory authorities regarding the method and extent ofremediation at each site, existing technology, prior experience in contaminatedsite remediation and the apportionment of costs among potentially responsibleparties. Grace expects that the funding of environmental remediation activitieswill be affected by the Chapter 11 proceedings.

At September 30,2006, Grace’s estimated liability for environmental investigative andremediation costs totaled $363.2 million, as compared with $342.0 million atDecember 31, 2005. The amount is based on funding and/or remediation agreementsin place and Grace’s best estimate of its cost for sites not subject to aformal remediation plan. Grace’s estimated environmental liabilities areincluded in “liabilities subject to compromise” in the accompanyingConsolidated Balance Sheets.

For the periodended June 30, 2006, Grace recorded pre-tax charges of $30.0 million forenvironmental matters.  Of the pre-taxcharges, $28.0 million was in connection with a cost recovery lawsuit broughtby the U.S. Government and was necessary based on a recent communication fromthe U.S. Department of Justice delineating asserted reimbursable spendingduring the 2002 through 2005 period, as described below.  The remainder of the pre-tax charges wereattributable to the ongoing review of recorded environmental liabilities.

Net cashexpenditures charged against previously established reserves for the ninemonths ended September 30, 2006 and 2005 were $8.7 million and $26.1 million,respectively.  Cash expenditures in 2005 includeda settlement payment of $21.4 million related to a formerly owned site.

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*VermiculiteRelated Matters*

EPA Lawsuit—InNovember 1999, Region 8 of the Environmental Protection Agency (“EPA”) began aninvestigation into alleged excessive levels of asbestos-related disease in theLibby population related to Grace’s former mining activities in Libby, Montana.This investigation led the EPA to undertake additional investigative activityand to carry out response actions in and around Libby. On March 30, 2001, theEPA filed a lawsuit in U.S. District Court for the District of Montana, MissoulaDivision (*United States v. W. R. Grace & Company et al.*)under the Comprehensive Environmental Response, Compensation and Liability Actfor the recovery of costs allegedly incurred by the United States in responseto the release or threatened release of asbestos in the Libby, Montana arearelating to such former mining activities. These costs include cleaning and/ordemolition of contaminated buildings, excavation and removal of contaminatedsoil, health screening of Libby residents and former mine workers, andinvestigation and monitoring costs. In this action, the EPA also sought adeclaration of Grace’s liability that would be binding in future actions torecover further response costs.

In December 2002,the District Court granted the United States’ motion for partial summaryjudgment on a number of issues that limited Grace’s ability to challenge theEPA’s response actions. In January 2003, a trial was held on the remainder ofthe issues, which primarily involved the reasonableness and adequacy of documentationof the EPA’s cost recovery claims through December 31, 2001. On August 28,2003, the District Court issued a ruling in favor of the United States thatrequires Grace to reimburse the government for $54.5 million (plus interest) incosts expended through December 2001, and for all appropriate future costs tocomplete the remediation activities. The Ninth Circuit Court of Appeals upheldthe District Court’s rulings.  Grace’spetition for the U.S. Supreme Court to hear the case was denied.

Grace’s totalestimated liability for vermiculite-related remediation, including the cost ofremediation of vermiculite processing sites outside of Libby, at September 30,2006 and December 31, 2005 was $255.7 million and $226.2 million, respectively.  The estimate at September 30, 2006 includes $164.4million for asserted reimbursable costs through 2005, including the chargetaken in the second quarter of 2006. The current estimate does not include thecost to remediate the Grace-owned mine site at Libby or other nearby propertiesthat may require remediation, which costs are not currently estimable. Grace’sestimate of costs is based on U.S. Government spending data through December31, 2005, public comments regarding the EPA’s spending plans, discussions ofspending forecasts with EPA representatives, analysis of other information madeavailable from the EPA, and evaluation of probable remediation costs atvermiculite processing sites. However, the EPA’s cost estimates have increasedregularly and substantially over the course of this remediation. Consequently,as the EPA’s spending on these matters increases, Grace’s liability forremediation will increase.  Grace hasbeen informed that the U.S. Government is attempting to estimate the futurecost of this environmental remediation. This information may require Grace to increase its estimate of liabilityand the increase could be material.

MontanaCriminal Proceeding**—**OnFebruary 7, 2005, the United States Department of Justice announced theunsealing of a grand jury indictment against Grace and seven current or formersenior level employees *(United States ofAmerica v. W. R. Grace & Co. et al)* relating to Grace’s formervermiculite mining and processing activities in Libby, Montana.  The indictment accuses the defendants of (1)conspiracy to violate environmental laws and obstruct federal agencyproceedings; (2) violations of the federal Clean Air Act; and (3) obstructionof justice.

Grace purchased the Libbymine in 1963 and operated it until 1990; vermiculite processing activitiescontinued until 1992. The grand jury charges that the conspiracy took placefrom 1976 to 2002.  According to the U.S.Department of Justice, Grace could be subject to fines in an amount equal totwice the after-tax profit earned from its Libby operations or twice thealleged loss suffered by victims, plus additional amounts for restitution tovictims. The indictment alleges that such after tax profits were $140 million.Grace has categorically denied any criminal wrongdoing and intends tovigorously defend itself at trial.

In March 2005, the U.S.District Court for the District of Montana entered a scheduling order setting atrial date of September 11, 2006.  InJuly

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2006, the Court dismisseda portion of the conspiracy count of a superseding indictment allegingconspiracy to knowingly endanger residents of the Libby area and others inviolation of the Clean Air Act.  InAugust 2006, the Court granted a motion by the defendants to exclude asevidence sample results that included minerals that do not constitute asbestosunder the Clean Air Act.  The Governmenthas appealed these and other rulings to the Ninth Circuit Court ofAppeals.  As a result of the appeal, thetrial has been delayed until September 2007 or later pending resolution of theappeals.

The U.S. Bankruptcy Courtpreviously granted Grace’s request to advance legal and defense costs to the employees,subject to a reimbursement obligation if it is later determined that theemployees did not meet the standards for indemnification set forth under theappropriate state corporate law. For the nine months ended September 30, 2006and 2005, total expense for Grace and the employees was $48.2 million and $12.8million respectively, which amounts are included in selling, general andadministrative expenses in the accompanying Consolidated Statements ofOperations.  Cumulative expenses toaddress this matter were $68.2 million through September 30, 2006.

Grace is unable to assess whether the indictment, orany conviction resulting therefrom, will have a material adverse effect on theresults of operations or financial condition of Grace or affect Grace’sbankruptcy proceedings. While the appeal is pending, Grace expects legal feesfor this matter to be $2 million to $4 million per quarter.  Grace intends to expense such costs as theyare incurred.

New Jersey Lawsuit—OnJune 1, 2005, the New Jersey Department of Environmental Protection (“DEP”)filed a lawsuit against Grace and two former employees seeking civil penaltiesfor alleged misrepresentations and false statements made in a PreliminaryAssessment/Site Investigation Report and Negative Declarations submitted byGrace to the DEP in 1995 pursuant to the New Jersey Industrial Site RecoveryAct. Grace submitted the Report, which was prepared by an independentenvironmental consultant, in connection with the closing of Grace’s formerplant in Hamilton Township, New Jersey. Grace is also aware that the State ofNew Jersey and U.S. Department of Justice each are conducting criminalinvestigations related to Grace’s former operations of such plant.

Grace purchasedthe Hamilton plant assets in 1963 and ceased operations in 1994. During theoperating period, Grace produced spray-on fire protection products andvermiculite-based products at this plant. The current property owners areconducting remediation activities as directed by the EPA.  The property owners and the EPA have filedproofs of claim against Grace in the amount of approximately $4 million withrespect to the Hamilton plant site.

Grace is unable at this time to assess the effect ofthis lawsuit or the pending criminal investigations on Grace’s results ofoperations, cash flows, or liquidity, or on its bankruptcy proceeding.

*Non-VermiculiteRelated Matters*

At September 30,2006 and December 31, 2005, Grace’s estimated liability for remediation ofsites not related to its former vermiculite mining and processing activitieswas $107.5 million and $115.8 million, respectively. This liability relates toGrace’s current and former operations, including its share of liability foroff-site disposal at facilities where it has been identified as a potentially responsibleparty.  Grace’s estimated liability isbased upon an evaluation of claims for which sufficient information wasavailable. As Grace receives new information and continues its claimsevaluation process, its estimated liability may change materially.

***Tax Matters***—In 2005, Grace settled allproposed tax adjustments with the Internal Revenue Service (the “IRS”) withrespect to the 1993-1996 Federal income tax audit, and paid applicable taxesand interest of $90.0 million, with the exception of approximately $7.0 millionof proposed adjustments relating to research and experimentation credits, withrespect to which a settlement is currently under discussion with the IRS.

As a consequenceof resolving federal tax adjustments for the 1993-1996 tax periods, Grace owesapproximately $12 million in additional state taxes and accrued interest, whichwill be paid in accordance with Grace’s bankruptcy proceedings. 

In June 2006,Grace received revised examination reports from the IRS for the 1988-1989 and1997-2001 tax periods (collectively, the “Examination Reports”) asserting, inthe aggregate, approximately $32.5 million of net additional tax plus accruedinterest.  The most significant issueaddressed in the Examination Reports concerns the carryback of a specifiedliability loss from the 1998 tax period to the 1989 taxable year.  Since

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Grace was in a netoperating loss position for all but two of the other tax periods covered in theaudit, most of the other issues addressed in the Examination Reports, if determinedadversely to Grace, would be unlikely to result in any cash tax liability butrather would likely impact the amount of certain tax attributes claimed byGrace in those tax periods such as losses and credits.  On May 25, 2006, Grace filed a protest withthe IRS Office of Appeals with respect to this carry-back issue.  Grace’s federal tax returns covering 2002 andlater years are open for future examination by the IRS.

The IRS has assessed additional federal income taxwithholding and Federal Insurance Contributions Act taxes plus interest andrelated penalties for calendar years 1993 through 1998 against a Gracesubsidiary that formerly operated a temporary staffing business for nurses andother health care personnel. In August 2006, Grace agreed with the U.S.Department of Justice and the IRS on a settlement amount of $13.0 million andother terms that would resolve the matter. Grace has a right to indemnification from its former partner in thebusiness for approximately $2.6 million of the settlement amount. Thesettlement has been approved by the Bankruptcy Court, but remains subject tothe execution of written closing agreements with the IRS and the Department ofJustice.

In September 2006, the German Ministry of Financeissued guidance that excludes Grace’s German subsidiary from the application ofa law that was effective in 2005 prohibiting interest deductions in relation tocertain related party loans.

Grace recorded a $12.0 million reduction in thirdquarter 2006 tax expense as a result of the resolution of the two foregoingissues.

As of December 31, 2005, Grace had approximately $112.6million in net operating loss (“NOL”) carryforwards. Grace anticipates generatingadditional NOLs upon emergence from bankruptcy as contemplated in thePlan.  Because Grace did not pay asignificant amount of U.S. taxes in prior years and/or has already received taxrefunds from available NOL carryback years, it expects to carryforward most ofits current and anticipated NOLs. Under federal income tax law, a corporationis generally permitted to carryforward NOLs for a 20-year period for deductionagainst future taxable income. Grace’s ability to deduct NOL carryforwardscould be significantly limited if it were to undergo an ownership change duringor as a result of the Chapter 11 Cases. During the course of the bankruptcy proceeding, the Bankruptcy Courtentered an order that places certain limitations on trading in Grace commonstock or options convertible into Grace common stock.  Pursuant to these limitations, Grace intendsto object to any purchase of Grace common stock or options that wouldpotentially contribute to an ownership change. However, Grace can provide no assurance that these limitations willprevent an ownership change or that its ability to utilize net operating losscarryforwards will not be significantly limited as a result of Grace’sreorganization.

***Purchase Commitments*—**Grace engages inpurchase commitments to minimize the volatility of major components of directmanufacturing costs including natural gas, certain metals, asphalt, amines andother materials.  Such commitments arefor quantities that Grace fully expects to use in its normal operations.

***Guarantees and Indemnification Obligations*—**Grace is a party to many contracts containing guarantees andindemnification obligations. These contracts primarily consist of:

·                  Contractsproviding for the sale of a former business unit or product line in which Gracehas agreed to indemnify the buyer against liabilities arising prior to theclosing of the transaction, including environmental liabilities. Theseliabilities are included in “liabilities subject to compromise” in theaccompanying Consolidated Balance Sheets.

·                  Guaranteesof real property lease obligations of third parties, typically arising out of(a) leases entered into by former subsidiaries of Grace, or (b) the assignmentor sublease of a lease by Grace to a third party. These obligations areincluded in “liabilities subject to compromise” in the accompanyingConsolidated Balance Sheets.

·                  Licensesof intellectual property by Grace to third parties in which Grace has agreed toindemnify the licensee against third party infringement claims.

·                  Contractsentered into with third party consultants, independent contractors, and other

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service providers in which Grace has agreed toindemnify such parties against certain liabilities in connection with theirperformance. Based on historical experience and the likelihood that suchparties will make a claim against Grace, Grace believes that suchindemnification obligations are immaterial.

·                  Productwarranties with respect to certain products sold to customers in the ordinarycourse of business. These warranties typically provide that product willconform to specifications. Grace generally does not establish a liability forproduct warranty based on a percentage of sales or other formula. Grace accruesa warranty liability on a transaction-specific basis depending on theindividual facts and circumstances related to each sale. Both the liability andannual expense related to product warranties are immaterial to the ConsolidatedFinancial Statements.

***FinancialAssurances*****—**Financialassurances have been established for a variety of purposes, including insuranceand environmental matters, asbestos settlements and appeals, trade-relatedcommitments and other matters.  AtSeptember 30, 2006, Grace had gross financial assurances issued and outstandingof $256.1 million, comprised of $135.0 million of surety bonds issued byvarious insurance companies, and $121.1 million of standby letters of creditand other financial assurances issued by various banks. As discussed in Note 8,$48.7 million of these financial assurances have been issued under the DIPfacility.

***Accounting for Contingencies*****—**Although the outcome of each of the matters discussedabove cannot be predicted with certainty, Grace has assessed its risk and hasmade accounting estimates as required under U.S. generally accepted accountingprinciples. As a result of the Filing, claims related to certain of the itemsdiscussed above will be addressed as part of Grace’s Chapter 11 proceedings.Accruals recorded for such contingencies have been included in “liabilitiessubject to compromise” in the accompanying Consolidated Balance Sheets. Theamounts of these liabilities as ultimately determined through the Chapter 11proceedings could be materially different from amounts recorded at September30, 2006.

**13.   PensionPlans and Other Postretirement Benefit Plans**

***Pension Plans—***Gracemaintains defined benefit pension plans covering employees of certain units whomeet age and service requirements. Benefits are generally based on finalaverage salary and years of service. Grace funds its U.S. qualified pensionplans (“U.S. qualified pension plans”) in accordance with U.S. federal laws andregulations. Non-U.S. pension plans (“non-U.S. pension plans”) are funded undera variety of methods, as required under local laws and customs.

Grace also provides, through nonqualified plans,supplemental pension benefits in excess of U.S. qualified pension plan limitsimposed by federal tax law. These plans cover officers and higher-levelemployees and serve to increase the combined pension amount to the level thatthey otherwise would have received under the U.S. qualified pension plans inthe absence of such limits. The nonqualified plans are unfunded and Grace paysthe costs of benefits as they are incurred.

At the December 31, 2005 measurement date for Grace’sdefined benefit pension plans (the “Plans”), the accumulated benefit obligation(“ABO”) was approximately $1,386 million as measured under U.S. generallyaccepted accounting principles. At September 30, 2006, Grace’s recorded pensionliability for underfunded plans was $481.6 million ($392.6 million included inliabilities not subject to compromise and $89.0 million related to supplementalpension benefits, included in “liabilities subject to compromise”). Therecorded liability reflects 1) the shortfall between dedicated assets and theABO of underfunded plans ($254.8 million); and 2) the ABO of pay-as-you-goplans ($226.8 million).

***Postretirement Benefits Other Than Pensions***—Grace provides postretirement healthcare and life insurance benefits (referred to as other post-employment benefitsor “OPEB”) for retired employees of certain U.S. business units and certaindivested units.  The postretirementmedical plan provides various levels of benefits to employees hired before 1991who retire from Grace after age 55 with at least 10 years of service.  These plans are unfunded and Grace pays aportion of the costs of benefits under these plans as they are incurred. Graceapplies SFAS No. 106, “Employers’ Accounting for Postretirement Benefits OtherThan Pensions,” which requires that the future costs of

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postretirement health care and life insurance benefitsbe accrued over the employees’ years of service.

Retirees and beneficiaries covered by thepostretirement medical plan are required to contribute a minimum of 40% of thecalculated premium for that coverage. During 2002, per capita costs under theretiree medical plans exceeded caps on the amount Grace was required tocontribute under a 1993 amendment to the plan. As a result, for 2003 and futureyears, retirees will bear 100% of any increase in premium costs.

For 2006 measurement purposes, per capita costs,before retiree contributions, were assumed to initially increase at a rate of8.5%.  The rate is assumed to decrease graduallyto 5.0% through 2010 and remain at that level thereafter.  A one percentage point increase or decreasein assumed health care medical cost trend rates would have a negligible impacton Grace’s postretirement benefit obligations.

The components of net periodic benefit cost (income)for the three months and nine months ended September 30, 2006 and 2005 are asfollows:
| ** **                                                           | ** ** | **Three Months Ended September 30,** | ** ** |
|----------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                           | ** ** | **2006**                                                 | ** ** | **2005** | ** ** |
| **Components of Net  Periodic Benefit Cost (Income)** | ** ** | **Pension**                                              | ** ** | ** ** | ** ** | **Pension** | ** ** | ** ** | ** ** |
| ***(In millions)***                                             | ** ** | **U.S.**                                                 | ** ** | **Non-U.S.** | ** ** | **OPEB** | ** ** | **U.S.** | ** ** | **Non-U.S.** | ** ** | **OPEB** | ** ** |
| Service cost                                                         | ** ** | **$**                                                    | **4.1**    | ** ** | **$** | **2.1** | ** ** | **$** | **0.1** |   | $ | 4.1 |   | $ | 1.5 |   | $ | (0.1 | ) |
| Interest cost                                                        | ** ** | **14.5**                                                 | ** ** | **4.6** | ** ** | **1.0** |   | 14.4 |   | 4.4 |   | 1.3 |   |
| Expected return  on plan assets                                      | ** ** | **(13.3**                                                | **)**      | **(4.5** | **)** | **—** |   | (12.8 | ) | (3.9 | ) | — |   |
| Amortization of  prior service cost                                  | ** ** | **0.7**                                                  | ** ** | **0.2** | ** ** | **(2.6** | **)** | 1.3 |   | 0.1 |   | (3.1 | ) |
| Amortization of  unrecognized actuarial loss                         | ** ** | **5.7**                                                  | ** ** | **1.8** | ** ** | **0.1** |   | 5.8 |   | 2.4 |   | 0.4 |   |
| Net curtailment  and settlement loss                                 | ** ** | **—**                                               | ** ** | **—** | ** ** | **—** |   | — |   | — |   | — |   |
| **Net periodic benefit cost  (income)**                              | ** ** | **$**                                                    | **11.7**   | ** ** | **$** | **4.2** | ** ** | **$** | **(1.4** | **)** | $ | 12.8 |   | $ | 4.5 |   | $ | (1.5 | ) |

 
| ** **                                                      | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                      | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| **Components of Net  Periodic Benefit Cost (Income)** | ** ** | **Pension**                                             | ** ** | ** ** | ** ** | **Pension** | ** ** | ** ** | ** ** |
| ***(In millions)***                                        | ** ** | **U.S.**                                                | ** ** | **Non-U.S.** | ** ** | **OPEB** | ** ** | **U.S.** | ** ** | **Non-U.S.** | ** ** | **OPEB** | ** ** |
| Service cost                                                    | ** ** | **$**                                                   | **12.2**   | ** ** | **$** | **6.2** | ** ** | **$** | **0.3** |   | $ | 12.3 |   | $ | 5.3 |   | $ | 0.3 |   |
| Interest cost                                                   | ** ** | **43.6**                                                | ** ** | **13.1** | ** ** | **3.0** |   | 43.4 |   | 13.1 |   | 3.7 |   |
| Expected return  on plan assets                                 | ** ** | **(39.8**                                               | **)**      | **(13.3** | **)** | **—** |   | (38.4 | ) | (11.8 | ) | — |   |
| Amortization of  prior service cost                             | ** ** | **1.9**                                                 | ** ** | **0.5** | ** ** | **(7.8** | **)** | 3.9 |   | 0.5 |   | (9.5 | ) |
| Amortization of  unrecognized actuarial loss                    | ** ** | **17.2**                                                | ** ** | **5.9** | ** ** | **0.3** |   | 17.2 |   | 6.2 |   | 1.2 |   |
| Net curtailment  and settlement loss                            | ** ** | **—**                                              | ** ** | **—** | ** ** | **—** |   | 1.1 |   | 1.6 |   | — |   |
| **Net periodic benefit cost  (income)**                         | ** ** | **$**                                                   | **35.1**   | ** ** | **$** | **12.4** | ** ** | **$** | **(4.2** | **)** | $ | 39.5 |   | $ | 14.9 |   | $ | (4.3 | ) |

 

***Plan Contributions and Funding***—Subject to the approval of theBankruptcy Court, Grace intends to satisfy its obligations under the Plans andto comply with all of the requirements of the Employee Retirement IncomeSecurity Act of 1974.  On June 16, 2006,Grace obtained Bankruptcy Court approval to fund minimum required payments ofapproximately $92 million for the period from July 2006 through January2007.  These estimated payments reflectthe impact of the Pension Protection Act of 2006, which extended the interestrates required under the Pension Funding Equity Act of 2004 for plan yearscommencing in 2006 and 2007. In that regard, Grace contributed approximately$20 million in July 2006, approximately $45 million in September 2006 andapproximately $6 million in October 2006, to the trusts that hold assets of thePlans.  However, there can be noassurance that the Bankruptcy Court will continue to approve arrangements tosatisfy the funding needs of the Plans. Contributions to non-U.S. plans are notsubject to Bankruptcy Court approval and Grace intends to fund such plans basedon actuarial and trustee recommendations.

Grace plans to paybenefits as they become due under virtually all pay-as-you-go plans and tomaintain compliance with federal funding laws for its U.S. qualified pensionplans.

**14.   OperatingSegment Information**

Grace is a globalproducer of specialty chemicals and materials. It generates revenues from twooperating segments: Grace Davison, which includes silica- and alumina-basedcatalysts and

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materials used ina wide range of industrial applications; and Grace Performance Chemicals, whichincludes specialty chemicals and materials used in commercial and residentialconstruction and in rigid food and beverage packaging. Intersegment sales,eliminated in consolidation, are not material. The table below presents information related to Grace’s operatingsegments for the three months and nine months ended September 30, 2006 and2005, respectively. Only those corporate expenses directly related to theoperating segments are allocated for reporting purposes. All remainingcorporate items are reported separately and labeled as such.
| **Operating  Segment Data**

***(In millions)*** | ** ** | **Three Months  Ended  September 30,** | ** ** | **Nine Months  Ended  September 30,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                 | ** ** | **2006**                                         | ** ** | **2005**                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Net  Sales**                                             |       |                                             |       |                                            |       |   |   |   |   |
| Grace Davison                                              | ** ** | **$**                                            | **396.5**  |                                            | $          | 338.3 | ** ** | **$** | **1,133.2** |   | $ | 1,031.9 |   |
| Grace Performance  Chemicals                               | ** ** | **344.9**                                        |       | 315.1                                           | ** ** | **995.9** |   | 901.2 |   |
| **Total**                                                  | ** ** | **$**                                            | **741.4**  |                                            | $          | 653.4 | ** ** | **$** | **2,129.1** |   | $ | 1,933.1 |   |
| **Pre-tax  Operating Income**                              |       |                                             |       |                                            |       |   |   |   |   |
| Grace Davison                                              | ** ** | **$**                                            | **45.6**   |                                            | $          | 36.8 | ** ** | **$** | **127.9** |   | $ | 117.6 |   |
| Grace  Performance Chemicals                               | ** ** | **51.9**                                         |       | 45.5                                            | ** ** | **139.2** |   | 118.5 |   |
| Corporate costs                                            | ** ** | **(26.4**                                        | **)**      | (23.2                                           | )          | **(77.5** | **)** | (80.7 | ) |
| **Total**                                                  | ** ** | **$**                                            | **71.1**   |                                            | $          | 59.1 | ** ** | **$** | **189.6** |   | $ | 155.4 |   |

 

Corporate costsinclude expenses of corporate headquarters functions incurred in support ofcore operations, such as corporate financial and legal services, humanresources management, communications and regulatory affairs. Corporate costsalso include certain pension and postretirement benefits, including theamortization of deferred costs that are considered a core operating expense butnot allocated to operating segments.

The followingtable presents information related to the geographic areas in which Graceoperated for the three months and nine months ended September 30, 2006 and2005, respectively.
| **Geographic Area Data**

***(In millions)*** | ** ** | **Three Months  Ended  September 30,** | ** ** | **Nine Months  Ended  September 30,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                   | ** ** | **2006**                                         | ** ** | **2005**                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Net  Sales**                                               |       |                                             |       |                                            |       |   |   |   |   |
| United States                                                | ** ** | **$**                                            | **268.7**  |                                            | $          | 244.0 | ** ** | **$** | **775.6** |   | $ | 719.9 |   |
| Canada and Puerto Rico                                       | ** ** | **39.0**                                         |       | 41.0                                            | ** ** | **105.0** |   | 106.2 |   |
| Total North America                                          | ** ** | **$**                                            | **307.7**  |                                            | $          | 285.0 | ** ** | **$** | **880.6** |   | $ | 826.1 |   |
| Germany                                                      | ** ** | **37.7**                                         |       | 32.0                                            | ** ** | **103.1** |   | 90.5 |   |
| Europe, other than Germany                                   | ** ** | **243.5**                                        |       | 200.5                                           | ** ** | **694.1** |   | 607.9 |   |
| Total Europe                                                 | ** ** | **$**                                            | **281.2**  |                                            | $          | 232.5 | ** ** | **$** | **797.2** |   | $ | 698.4 |   |
| Asia Pacific                                                 | ** ** | **113.7**                                        |       | 98.9                                            | ** ** | **340.4** |   | 304.6 |   |
| Latin America                                                | ** ** | **38.8**                                         |       | 37.0                                            | ** ** | **110.9** |   | 104.0 |   |
| Total                                                        | ** ** | **$**                                            | **741.4**  |                                            | $          | 653.4 | ** ** | **$** | **2,129.1** |   | $ | 1,933.1 |   |

 

The pre-taxoperating income for Grace’s operating segments for the three months and ninemonths ended September 30, 2006 and 2005, respectively, is reconciled below toincome (loss) before income taxes and minority interest presented in theaccompanying Consolidated Statements of Operations.

** **
| **Reconciliation of  Operating Segment Data to Financial Statements**

***(In millions)*** | ** ** | **Three Months  Ended  September 30,** | ** ** | **Nine Months  Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2006**                                         | ** ** | **2005**                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Pre-tax  operating income—core operations                                                  | ** ** | **$**                                            | **71.1**   |                                            | $          | 59.1 | ** ** | **$** | **189.6** |   | $ | 155.4 |   |
| Minority  interest                                                                              | ** ** | **7.9**                                          |       | 7.4                                             | ** ** | **26.2** |   | 18.4 |   |
| Chapter 11  expenses, net                                                                       | ** ** | **(12.0**                                        | **)**      | (9.3                                            | )          | **(32.2** | **)** | (19.9 | ) |
| Net gain (loss)  on sales of investments and disposals of assets                                | ** ** | **(0.2**                                         | **)**      | (1.4                                            | )          | **2.6** |   | (0.9 | ) |
| Provision for  environmental remediation                                                        | ** ** | **—**                                       |       | —                                          | ** ** | **(30.0** | **)** | — |   |
| Interest expense  and related financing costs                                                   | ** ** | **(18.8**                                        | **)**      | (13.4                                           | )          | **(54.5** | **)** | (41.3 | ) |
| Other, net                                                                                      | ** ** | **(24.1**                                        | **)**      | (5.5                                            | )          | **(56.8** | **)** | 0.6 |   |
| Income (loss) before  income taxes and minority interest                                        | ** ** | **$**                                            | **23.9**   |                                            | $          | 36.9 | ** ** | **$** | **44.9** |   | $ | 112.3 |   |

 

Minority interest primarily pertains to AdvancedRefining Technologies LLC (“ART”), a joint venture between Grace and ChevronProducts Company where Grace has a 55% economic interest.

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

** **

**Financial Summary for September 30,2006**

Following is asummary analysis of key financial measures of our performance for the three monthsand nine months ended September 30, 2006 compared with the prior yearperiods.

·                  Salesincreased 13.5% and 10.1% for the three months and nine months ended September 30,2006, respectively, primarily as a result of higher sales volume in allgeographic regions, improved product mix, and selling price increases inresponse to cost inflation.

·                  Netresults for each period has been primarily affected by: 1) the performance ofour businesses—which is categorized as “core operations”; and 2) the impact oflegal contingencies and other nonoperating liabilities—which is categorized as “noncoreactivities.”

·                  Netincome was $18.4 million for the three months ended September 30,2006, compared with net income of $32.1 million for the three months endedSeptember 30, 2005.  Net income was$13.3 million for the nine months ended September 30, 2006, comparedwith net income of $67.9 for the nine months ended September 30,2005.  The lower net income in the threemonths and nine months ended September 30, 2006, as compared to the 2005periods, was principally due to increases in our pre-tax loss from noncoreactivities and costs of Chapter 11, partially offset by the resolution ofcertain tax matters at amounts lower than previously estimated.

·                  Pre-taxincome from core operations increased 20.3% and 22.0% for the three months andnine months ended September 30, 2006, respectively, primarily attributableto higher sales volume in all geographic regions, higher selling prices topartially offset cost inflation, and lower overall pension costs.

·                  Pre-taxoperating income of our Grace Performance Chemicals operating segment increased14.1% and 17.5% for the three months and nine months ended September 30,2006, respectively, attributable principally to higher sales of products usedin commercial and residential construction.

·                  Pre-taxoperating income of our Grace Davison operating segment increased 23.9% and8.8% for the three months and nine months ended September 30, 2006,respectively, attributable primarily to higher sales of specialty materials andcatalysts used in refining, chemical, and industrial applications.

·                  Operatingcash flow for the nine months ended September 30, 2006 was $49.4 millioncompared with $14.8 million for the prior year period. The higher cashflow is attributable to improved operating results in 2006.  Other major factors affecting cash flows inthe periods include the payment of $119.7 million to settle tax andenvironmental contingencies in 2005 and an increase in 2006 of $76.7 millionto fund defined benefit pension arrangements.

·                  Pre-taxloss from noncore activities was $26.0 million in the third quarter of2006 compared with $7.7 million in the prior year quarter.  Pre-tax loss from noncore activities was$88.9 million year-to-date in 2006 compared with  $2.7 million in the prior yearperiod.  The third quarter andyear-to-date changes are principally due to a $30.0 million increase inthe estimated costs of environmental remediation recorded in the second quarterof 2006 and increases in legal defense costs in both periods for the criminalproceeding related to Grace’s former vermiculite mining operations inMontana.  Pre-tax loss from noncoreactivities in the prior year periods benefited from gains recorded from insurancerecoveries on pre-Chapter 11 environmental and asbestos-related costs.

We are attemptingto resolve noncore liabilities and contingencies through our Chapter 11proceeding. Our noncore liabilities include asbestos-related litigation,environmental remediation, tax disputes and business litigation. Our operatingstatements include periodic adjustments to account for changes in estimates ofsuch liabilities and developments in our Chapter 11 proceeding. Theseliabilities and contingencies may result in continued volatility in net resultsin the future.

We present the netcosts of our reorganization under Chapter 11 of the U.S. Bankruptcy Codeas “Chapter 11 expenses, net,” a separate caption in our ConsolidatedStatements of Operations. Chapter 11 expenses are not included in the 

 

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measures, incomefrom core operations and income (loss) from noncore operations.

**Description of Core Business**

We are engaged inspecialty chemicals and specialty materials businesses on a worldwide basisthrough our two operating segments:

***Grace Davison***includes:

**·**                  Catalysts and chemical additives used by petroleum refiners, includingfluid catalytic cracking, or FCC, catalysts, that help to “crack” thehydrocarbon chain in distilled crude oil to produce transportation fuels, suchas gasoline and diesel fuels, and other petroleum-based products, and FCCadditives used to reduce sulfur in gasoline, maximize propylene production fromrefinery FCC units, and reduce emissions of sulfur oxides, nitrogen oxides andcarbon monoxide from refinery FCC units;

**·**                  Hydroprocessing catalysts used by petroleum refiners in process reactorsto upgrade heavy oils into lighter, more useful products by removing impuritiessuch as nitrogen, sulfur and heavy metals, allowing less expensive feedstocksto be used in the petroleum refining process;

**·**                  Specialty catalysts, including polyolefin catalysts and catalyst supportsthat are essential components in the manufacture of polyethylene andpolypropylene resins, and other chemical catalysts used in a variety ofindustrial, environmental and consumer applications;

·                  Silica-basedand silica-alumina-based engineered materials used in:

·                  industrialmarkets, such as coatings, plastics and rubber, precision investment casting,refractory, insulating glass windows, desiccants, and gas and liquidspurification;

·                  consumerapplications, such as food products, toothpaste, pharmaceutical and personalcare products, and the processing of edible oils and beverages;

·                  digitalmedia coatings on ink jet papers; and

·                  Silica-basedmaterials and chromatography columns, instruments, consumables and accessoriesused in life and analytical sciences applications.

We conduct ourhydroprocessing catalyst business through Advanced Refining Technologies, LLC,or ART, our joint venture with Chevron Products Company.  We report 100% of the revenues of our ARTjoint venture, but only receive 55% of the income after the minority interestis allocated to Chevron.

Key externalfactors for our FCC catalysts and hydroprocessing catalysts are the economicsof the petroleum refining industry, specifically the impacts of demand fortransportation fuels and petrochemical products, and crude oil supply.

Sales of our otherthree Grace Davison product groups are affected by general economic conditionsincluding the underlying growth rate of targeted end-use applications.

***Grace Performance Chemicals*** includes:

**·**                  Construction materials and systems, including concrete admixtures andfibers used to improve the durability and working properties of concrete,additives used in cement processing to improve energy efficiency and enhancethe characteristics of finished cement, waterproofing materials used incommercial and residential construction and renovation to protect buildingsfrom water penetration, and fireproofing materials used to protect buildingsfrom structural failure in the event of fire; and

**·**                  Packaging technologies, primarily specialty sealants and coatings used inrigid food and beverage packages, including can and closure sealants used toseal and enhance the shelf life of can and bottle contents, and coatings forcans and closures that prevent metal corrosion, protect package contents fromthe influence of metal and ensure proper adhesion of sealing compounds.

Construction productssales are affected by non-residential construction activity and, to a lesserextent, residential construction activity, which tend to lag the generaleconomy in both decline and recovery. Waterproofing products sales are alsosignificantly affected by residential renovation activity. A significantportion of our sales of construction products is in the U.S., so we are 

 

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strongly influenced bythe level of U.S. construction activity.

Our packagingtechnologies sales are affected by general economic conditions globally as wellas an ongoing shift in demand from metal and glass to plastic packaging forfoods and beverages. This shift is causing a decline in can sealant usage, butprovides opportunities for closure sealants and other products for plasticpackaging.

***Global scope***—We operate our business on a global scale with morethan 60% of our revenue and 40% of our operating properties outside the UnitedStates. Our business is conducted in more than 40 countries and in more than 20currencies. Our operating segments are managed on a global basis, servingglobal markets, with currency fluctuations in relation to the U.S. dollaraffecting reported earnings, net assets and cash flows.

The table below shows thesales in each of our operating segments, and domestic and international sales,as a percentage of our total sales.
| **Percentage of Total Grace Sales** | ** ** | **Three Months  Ended  September 30,** | ** ** | **Nine Months  Ended  September 30,** | ** ** |
|---------------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                              | ** ** | **2006**                                         | ** ** | **2005**                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Grace Davison                                           | ** ** | **53.5**                                         | **%**      | 51.8                                            | %          | **53.2** | **%** | 53.4 | % |
| Grace  Performance Chemicals                            | ** ** | **46.5**                                         | **%**      | 48.2                                            | %          | **46.8** | **%** | 46.6 | % |
| **Total**                                               | ** ** | **100.0**                                        | **%**      | 100.0                                           | %          | **100.0** | **%** | 100.0 | % |
| Grace U.S.                                              | ** ** | **36.3**                                         | **%**      | 37.3                                            | %          | **36.4** | **%** | 37.2 | % |
| Grace non-U.S.                                          | ** ** | **63.7**                                         | **%**      | 62.7                                            | %          | **63.6** | **%** | 62.8 | % |
| **Total**                                               | ** ** | **100.0**                                        | **%**      | 100.0                                           | %          | **100.0** | **%** | 100.0 | % |

 

**Voluntary Bankruptcy Filing**

In response to a sharply increasing number of asbestos-relatedpersonal injury claims, on April 2, 2001, Grace and 61 of our United Statessubsidiaries and affiliates, including W. R. Grace & Co.—Conn.,filed voluntary petitions for reorganization under Chapter 11 of theUnited States Bankruptcy Code in the United States Bankruptcy Court for theDistrict of Delaware. Our non-U.S. subsidiaries and certain of our U.S.subsidiaries were not included in the Chapter 11 filing.

Under Chapter 11,we have continued to operate as debtors-in-possession under court protectionfrom creditors and claimants, while using the Chapter 11 process todevelop and implement a plan for addressing the asbestos-related claims. Sincethe Chapter 11 filing, the bankruptcy court has approved all motionsnecessary to conduct normal business activities.

On January 13, 2005, wefiled an amended plan of reorganization and related documents with thebankruptcy court. The plan of reorganization is supported by committeesrepresenting general unsecured creditors and equity holders, but is notsupported by committees representing asbestos personal injury claimants andasbestos property damage claimants or the representative of future asbestosclaimants. Under the terms of the plan of reorganization, a trust would beestablished to which all pending and future asbestos-related claims would bechanneled for resolution. The plan of reorganization can become effective onlyafter a vote of eligible creditors and with the approval of the bankruptcy courtand the U.S. District Court for the District of Delaware. See “Plan ofReorganization” below for more information.

**Critical Accounting Estimates**

The preparation offinancial statements in conformity with U.S. generally accepted accountingprinciples requires that we make estimates and assumptions affecting the assetsand liabilities reported at the date of the Consolidated Financial Statements,and the revenues and expenses reported for the periods presented. Actualamounts could differ from those estimates. Changes in estimates are recorded inthe period identified. Accounting measurements that are most affected by ourestimates of future events and are deemed to be critical accounting estimatesby our management are:

·                  Contingentliabilities which depend on an assessment of the probability of loss and anestimate of ultimate resolution cost, such as asbestos-related matters (seeNotes 2 and 3 to the Consolidated Financial Statements), environmentalremediation (see Note 12 to the Consolidated Financial Statements), incometaxes (see Note 12 to the Consolidated Financial Statements), andlitigation (see Note 12 to the Consolidated Financial Statements);

·                  Pensionand postretirement liabilities that depend on assumptions regarding participantlife spans, future inflation, discount rates and total returns on investedfunds (see Note 13 to the Consolidated Financial Statements);

 

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·                  Liabilitiesfor employee incentive compensation and customer rebates that depend onestimates of future sales or earnings;

·                  Depreciationand amortization periods for long-lived assets, including property andequipment, intangible, and other assets that depend on utilization assessments,future product and production plans and expected sales and cash flows; and

·                  Realizationvalues of various assets such as net deferred tax assets, trade receivables,inventories, insurance receivables, properties and equipment, and goodwillwhich depend on assessments of credit and other business risks, and projectionsof future income and cash flows.

The accuracy ofthese and other estimates may also be materially affected by the uncertaintiesarising under our Chapter 11 proceeding.

**Summary Financial Information andMetrics**

Set forth on thefollowing page is a chart that lists our key operating statistics, and dollarand percentage changes for the three months and nine months ended September 30,2006 and 2005. Please refer to this Analysis of Continuing Operations chartwhen reading Management’s discussionand analysis of financial condition and resultsof operations.

In the Analysis ofContinuing Operations chart, as well as in the financial information presentedthroughout management’s discussion and analysis of financialcondition and results of operations, we present our financial results in the samemanner as results are reviewed internally. We break out our results of operations by operating segment and between “coreoperations” and “noncore activities.” Core operations comprise the financialresults of Grace Davison, Grace Performance Chemicals, and the costs ofcorporate activities that directly or indirectly support our businessoperations. In contrast, noncore activities comprise all other events andtransactions not directly related to the generation of operating revenue or thesupport of our core operations and generally relate to our former operationsand products. See “Pre-tax Income (Loss) from Noncore Activities” for moreinformation about noncore activities. We use pre-tax income from coreoperations as the performance factor in determining certain incentivecompensation and as the profitability factor in all significant businessdecisions.

Pre-taxincome from core operations, pre-tax income (loss) from noncore activities,pre-tax income from core operations as a percentage of sales, and pre-taxincome from core operations before depreciation and amortization do not purportto represent income or cash flow measures as defined under U.S. generallyaccepted accounting principles, and you should not consider them an alternativeto such measures as an indicator of our performance. We provide these measuresso you can distinguish the operating results of our current business base fromthe income and expenses of our past businesses, discontinued products, andcorporate legacies, and the effect of our Chapter 11 proceedings, and toensure that you understand the key data that management uses to evaluate ourresults of operations.

Pre-tax incomefrom core operations has material limitations as an operating performancemeasure because it excludes income and expenses that comprise our noncoreactivities, as presented in the Pre-tax Income (Loss) from Noncore Activitiestable in the “Grace Overview” section below. Income (loss) from noncoreactivities includes, among other things, provisions for asbestos-relatedlitigation and environmental remediation, income from insurance settlements,and legal defense costs, all of which have been material components of our netincome (loss). Pre-tax income from core operations before depreciation andamortization also has material limitations as an operating performance measuresince it excludes the impact of depreciation and amortization expense.  Our business is substantially dependent onthe successful deployment of our capital assets; therefore, depreciation andamortization expense is a necessary element of our costs and ability togenerate revenue. We compensate for the limitations of these measurements byusing these indicators together with net income (loss) as measured under U.S. generallyaccepted accounting principles to present a complete analysis of our results ofoperations.  You should evaluate pre-taxincome from core operations and pre-tax income from core operations beforedepreciation and amortization in conjunction with net income (loss) for a morecomplete analysis of our profitability.

 

I-32

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** **
| **Analysis of Continuing  Operations**

**(*In millions)***                 | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **$ Change  Fav (Unfav)** | ** ** | **% Change  Fav (Unfav)** | ** ** | **2006** | ** ** | **2005** | ** ** | **$ Change  Fav (Unfav)** | ** ** | **% Change  Fav (Unfav)** | ** ** |
| **Net  sales:**                                                                            | ** ** | ** **                                               | ** ** | ** **                                              |       |   |   |   |   |   |   |   |   |   | ** ** | ** ** | ** ** |
| Grace Davison                                                                              | ** ** | **$**                                                    | **396.5**  |                                                    | $          | 338.3 |   | $ | 58.2 |   | 17.2 | % | **$** | **1,133.2** |   | $ | 1,031.9 |   | $ | 101.3 |   | 9.8 | % |
| Grace Performance Chemicals                                                                | ** ** | **344.9**                                                |       | 315.1                                                   |       | 29.8 |   | 9.5 | % | **995.9** |   | 901.2 |   | 94.7 |   | 10.5 | % |
| **Total  Grace net sales**                                                                 | ** ** | **$**                                                    | **741.4**  |                                                    | $          | 653.4 |   | $ | 88.0 |   | 13.5 | % | **$** | **2,129.1** |   | $ | 1,933.1 |   | $ | 196.0 |   | 10.1 | % |
| **Pre-tax  operating income:**                                                             | ** ** | ** **                                               | ** ** | ** **                                              |       |   |   |   |   |   |   |   |   |   | ** ** | ** ** | ** ** |
| Grace Davison(1*)*                                                                         | ** ** | **$**                                                    | **45.6**   |                                                    | $          | 36.8 |   | $ | 8.8 |   | 23.9 | % | **$** | **127.9** |   | $ | 117.6 |   | $ | 10.3 |   | 8.8 | % |
| Grace Performance Chemicals                                                                | ** ** | **51.9**                                                 |       | 45.5                                                    |       | 6.4 |   | 14.1 | % | **139.2** |   | 118.5 |   | 20.7 |   | 17.5 | % |
| Corporate costs:                                                                           | ** ** | ** **                                               |       |                                                    |       |   |   |   | ** ** | ** ** |   |   |   |   |   |   |   |
| Support functions                                                                          | ** ** | **(11.5**                                                | **)**      | (8.9                                                    | )          | (2.6 | ) | (29.2 | %) | **(33.5** | **)** | (28.1 | ) | (5.4 | ) | (19.2 | %) |
| Pension, performance-related compensation, and other                                       | ** ** | **(14.9**                                                | **)**      | (14.3                                                   | )          | (0.6 | ) | (4.2 | %) | **(44.0** | **)** | (52.6 | ) | 8.6 |   | 16.3 | % |
| Total Corporate costs                                                                      | ** ** | **(26.4**                                                | **)**      | (23.2                                                   | )          | (3.2 | ) | (13.8 | %) | **(77.5** | **)** | (80.7 | ) | 3.2 |   | 4.0 | % |
| **Pre-tax  income from core operations**                                                   | ** ** | **71.1**                                                 |       | 59.1                                                    |       | 12.0 |   | 20.3 | % | **189.6** |   | 155.4 |   | 34.2 |   | 22.0 | % |
| **Pre-tax  income (loss) from noncore activities**                                         | ** ** | **(26.0**                                                | **)**      | (7.7                                                    | )          | (18.3 | ) | NM | ** ** | **(88.9** | **)** | (2.7 | ) | (86.2 | ) | NM |   |
| Interest expense                                                                           | ** ** | **(18.8**                                                | **)**      | (13.4                                                   | )          | (5.4 | ) | (40.3 | %) | **(54.5** | **)** | (41.3 | ) | (13.2 | ) | (32.0 | %) |
| Interest income                                                                            | ** ** | **1.7**                                                  |       | 0.8                                                     |       | 0.9 |   | 112.5 | % | **4.7** |   | 2.4 |   | 2.3 |   | 95.8 | % |
| **Income  (loss) before Chapter 11 expenses and income taxes**                        | ** ** | **28.0**                                                 |       | 38.8                                                    |       | (10.8 | ) | (27.8 | %) | **50.9** |   | 113.8 |   | (62.9 | ) | (55.3 | %) |
| Chapter 11 expenses, net                                                              | ** ** | **(12.0**                                                | **)**      | (9.3                                                    | )          | (2.7 | ) | (29.0 | %) | **(32.2** | **)** | (19.9 | ) | (12.3 | ) | (61.8 | %) |
| Benefit from (provision for) income taxes                                                  | ** ** | **2.4**                                                  |       | 2.6                                                     |       | (0.2 | ) | (7.7 | %) | **(5.4** | **)** | (26.0 | ) | 20.6 |   | 79.2 | % |
| **Net  income (loss)**                                                                     | ** ** | **$**                                                    | **18.4**   |                                                    | $          | 32.1 |   | $ | (13.7 | ) | (42.7 | %) | **$** | **13.3** |   | $ | 67.9 |   | $ | (54.6 | ) | (80.4 | %) |
| **Key  Financial Measures:**                                                               | ** ** | ** **                                               | ** ** | ** **                                              |       |   |   |   |   |   |   |   |   |   | ** ** | ** ** | ** ** |
| **Pre-tax  income from core operations as a percentage of sales:**                         | ** ** | ** **                                               | ** ** | ** **                                              |       |   |   |   |   |   |   |   |   |   | ** ** | ** ** | ** ** |
| Grace Davison                                                                              | ** ** | **11.5**                                                 | **%**      | 10.9                                                    | %          | NM |   | 0.6pts | ** ** | **11.3** | **%** | 11.4 | % | NM |   | (0.1)pts |   |
| Grace Performance Chemicals                                                                | ** ** | **15.0**                                                 | **%**      | 14.4                                                    | %          | NM |   | 0.6pts | ** ** | **14.0** | **%** | 13.1 | % | NM |   | 0.9pts |   |
| Total Core Operations                                                                      | ** ** | **9.6**                                                  | **%**      | 9.0                                                     | %          | NM |   | 0.6pts | ** ** | **8.9** | **%** | 8.0 | % | NM |   | 0.9pts |   |
| Total Core Operations adjusted for profit sharing of  joint ventures**(2)**                | ** ** | **10.7**                                                 | **%**      | 10.2                                                    | %          | NM |   | 0.5pts | ** ** | **10.1** | **%** | 9.0 | % | NM |   | 1.1pts |   |
| **Pre-tax  income from core operations before depreciation and amortization**              | ** ** | **$**                                                    | **100.3**  |                                                    | $          | 89.6 |   | $ | 10.7 |   | 11.9 | % | **$** | **275.3** |   | $ | 246.6 |   | $ | 28.7 |   | 11.6 | % |
| **As a percentage of sales**                                                               | ** ** | **13.5**                                                 | **%**      | 13.7                                                    | %          | NM |   | (0.2)pts | ** ** | **12.9** | **%** | 12.8 | % | NM |   | 0.1pts |   |
| **Depreciation  and amortization**                                                         | ** ** | **$**                                                    | **29.2**   |                                                    | $          | 30.5 |   | $ | 1.3 |   | 4.3 | % | **$** | **85.7** |   | $ | 91.2 |   | $ | 5.5 |   | 6.0 | % |
| **Gross  profit percentage (sales less cost of goods sold as a percent of sales)**(3)**:** | ** ** | ** **                                               | ** ** | ** **                                              |       |   |   |   |   |   |   |   |   |   | ** ** | ** ** | ** ** |
| Grace Davison                                                                              | ** ** | **30.0**                                                 | **%**      | 29.0                                                    | %          | NM |   | 1.0pts | ** ** | **29.6** | **%** | 29.9 | % | NM |   | (0.3)pts |   |
| Grace Performance Chemicals                                                                | ** ** | **34.9**                                                 | **%**      | 34.5                                                    | %          | NM |   | 0.4pts | ** ** | **34.6** | **%** | 34.1 | % | NM |   | 0.5pts |   |
| Total Grace                                                                                | ** ** | **32.1**                                                 | **%**      | 31.5                                                    | %          | NM |   | 0.6pts | ** ** | **31.8** | **%** | 31.6 | % | NM |   | 0.2pts |   |
| **Net  Consolidated Sales by Region:**                                                     | ** ** | ** **                                               |       |                                                    |       |   |   |   | ** ** | ** ** |   |   |   |   |   |   |   |
| North America                                                                              | ** ** | **$**                                                    | **307.7**  |                                                    | $          | 285.0 |   | $ | 22.7 |   | 8.0 | % | **$** | **880.6** |   | $ | 826.1 |   | $ | 54.5 |   | 6.6 | % |
| Europe                                                                                     | ** ** | **281.2**                                                |       | 232.5                                                   |       | 48.7 |   | 20.9 | % | **797.2** |   | 698.4 |   | 98.8 |   | 14.1 | % |
| Asia Pacific                                                                               | ** ** | **113.7**                                                |       | 98.9                                                    |       | 14.8 |   | 15.0 | % | **340.4** |   | 304.6 |   | 35.8 |   | 11.8 | % |
| Latin America                                                                              | ** ** | **38.8**                                                 |       | 37.0                                                    |       | 1.8 |   | 4.9 | % | **110.9** |   | 104.0 |   | 6.9 |   | 6.6 | % |
| **Total**                                                                                  | ** ** | **$**                                                    | **741.4**  |                                                    | $          | 653.4 |   | $ | 88.0 |   | 13.5 | % | **$** | **2,129.1** |   | $ | 1,933.1 |   | $ | 196.0 |   | 10.1 | % |

----

NM = Not meaningful

**(1)**                   Grace Davison pre-tax operating income includes minority interestrelated to the Advanced Refining Technologies joint venture.

**(2)**                   Reflects the add-back of minority interests in consolidatedsubsidiaries.

**(3)**                   Includes depreciation and amortization related tomanufacturing of products.

 

I-33

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**Grace Overview**

The following is an overview of our financial performance for the threemonths and nine months ended September 30, 2006 compared with the prioryear periods.

***Net Sales***—The following tablesidentify the period-over-period increase or decrease in sales attributable tochanges in product volume, product price and/or mix, and the impact of foreigncurrency translation.
| **Net Sales  Variance Analysis** | ** ** | **Three Months Ended September 30, 2006 as  a Percentage Increase  (Decrease) from Three Months Ended September 30, 2005** | ** ** |
|--------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **Volume**                                                                                                                                                                                       | ** ** | **Price/Mix** | ** ** | **Currency Translation** | ** ** | **Total** | ** ** |
| Grace Davison                              |       | 10.1                                                                                                                                                                                             | %          | 5.3 | % | 1.8 | % | 17.2 | % |
| Grace  Performance Chemicals               |       | 7.2                                                                                                                                                                                              | %          | 0.7 | % | 1.6 | % | 9.5 | % |
| Net sales                                  |       | 8.7                                                                                                                                                                                              | %          | 3.1 | % | 1.7 | % | 13.5 | % |
| **By  Region:**                            | ** ** | ** **                                                                                                                                                                                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| North America                              |       | 8.0                                                                                                                                                                                              | %          | (0.3 | %) | 0.3 | % | 8.0 | % |
| Europe                                     |       | 8.3                                                                                                                                                                                              | %          | 8.9 | % | 3.7 | % | 20.9 | % |
| Asia Pacific                               |       | 15.6                                                                                                                                                                                             | %          | (1.8 | %) | 1.2 | % | 15.0 | % |
| Latin America                              |       | 1.4                                                                                                                                                                                              | %          | 2.4 | % | 1.1 | % | 4.9 | % |

** **
| **Net Sales  Variance Analysis** | ** ** | **Nine Months Ended September 30, 2006 as  a Percentage Increase  (Decrease) from Nine Months Ended September 30, 2005** | ** ** |
|--------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **Volume**                                                                                                                                                                                     | ** ** | **Price/Mix** | ** ** | **Currency Translation** | ** ** | **Total** | ** ** |
| Grace Davison                              |       | 5.6                                                                                                                                                                                            | %          | 5.2 | % | (1.0 | %) | 9.8 | % |
| Grace  Performance Chemicals               |       | 8.0                                                                                                                                                                                            | %          | 3.0 | % | (0.5 | %) | 10.5 | % |
| Net sales                                  |       | 6.7                                                                                                                                                                                            | %          | 4.1 | % | (0.7 | %) | 10.1 | % |
| **By  Region:**                            | ** ** | ** **                                                                                                                                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| North America                              |       | 2.9                                                                                                                                                                                            | %          | 3.4 | % | 0.3 | % | 6.6 | % |
| Europe                                     |       | 10.8                                                                                                                                                                                           | %          | 6.0 | % | (2.7 | %) | 14.1 | % |
| Asia Pacific                               |       | 10.8                                                                                                                                                                                           | %          | 1.0 | % | 0.0 | % | 11.8 | % |
| Latin America                              |       | 3.1                                                                                                                                                                                            | %          | 1.4 | % | 2.1 | % | 6.6 | % |

 

Sales for the threemonths and nine months ended September 30, 2006 were favorably impacted byhigher volume, product mix, and selling price increases in response to costinflation.

***Pre-tax Income from Core Operations***—Operating profit for the three monthsand nine months ended September 30, 2006 improved due to sales volumegrowth and selling price increases, partially offset by raw material costinflation.

Corporate costsinclude corporate functional costs (such as financial and legal services, humanresources, communications and information technology), the cost of corporategovernance (including directors and officers liability insurance) and pensioncosts related to both corporate employees and to the effects of changes inassets and liabilities for all of our pension plans.  Corporate costs for the nine months endedSeptember 30, 2006 decreased compared with the prior year period primarilydue to lower pension expense from the effect of contributions made to definedbenefit pension plans in recent years.

We value our U.S.inventories under the last-in/first-out method, or LIFO, and our non-U.S.inventories under the first-in/first-out, or FIFO, method. LIFO was selected in1974 for U.S. financial reporting and tax purposes because it generally resultsin a better matching of current revenue with current costs during periods ofinflation. We have not elected LIFO for our non-U.S. inventories due tostatutory restrictions. However, if we valued our U.S. inventories using theFIFO method, consistent with our non-U.S. subsidiaries, our pre-tax income fromcore operations would have been approximately 8.6% lower for the nine monthsended September 30, 2006 and 4.1% higher for the nine months ended September 30,2005 (6% higher for all of 2005). The significant change in inventoryvaluations between FIFO and LIFO relates primarily to the price volatility,over the past several quarters, of commodity metals and natural gas used in GraceDavison products and production processes. We attempt to mitigate price volatility through hedging techniques suchas layering our needed supply under fixed delivery contracts, entering intocommodity option and swap contracts with suppliers and financial institutions,and by negotiating sales contracts that permit the partial pass-through ofmarket price increases for these volatile commodity items.

We normally attempt to lock in raw material coststhrough long-term supply contracts and targeted hedging programs. Arrangementsand programs can span a few months to several years. Major raw materialsinclude natural gas, certain metals, petroleum-based materials and certainindustrial chemicals. The actual cost of these raw materials can differsignificantly from spot prices at any point in time.  Our reported gross profit for the periodspresented has been favorably impacted by certain raw material supplyarrangements and unfavorably affected by others, relative to the then-currentmarket price. We expect that new supply agreements and hedging arrangementswill result in raw material costs that can be significantly favorable orunfavorable compared with prior periods. We attempt to mitigateperiod-over-period commodity-driven cost changes through utilization andcustomer pricing strategies; however, gross profit margins will likely beaffected when compared over time.

 

I-34

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***Pre-tax Income (Loss) from Noncore Activities***—Pre-taxincome (loss) from noncore activities reflects financial matters unrelated toour core operating units.  We expect thiscategory of costs and income to be volatile as potentially material items areaddressed through our Chapter 11 proceedings and the financialimplications of our legal contingencies become apparent. Some noncoreactivities are shown as separate items in the Consolidated Statements ofOperations.  Those not separately listedare primarily included in selling, general and administrative expenses and inother (income) expense. The following table shows the components of noncoreactivities:
| **Pre-tax Income (Loss) from Noncore Activities**

*** ****(In millions)* | ** ** | **Three Months  Ended  September 30,** | ** ** | **Nine Months  Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                                   | ** ** | **2006**                                         | ** ** | **2005**                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Provision for  environmental remediation—vermiculite                                                    | ** ** | **$**                                            | **—** |                                            | $          | — | ** ** | **$** | **(29.4** | **)** | $ | — |   |
| Provision for  environmental remediation—other sites                                                    | ** ** | **—**                                       |       | —                                          | ** ** | **(0.6** | **)** | — |   |
| Insurance  settlements—environmental and asbestos-related                                               | ** ** | **0.9**                                          |       | 4.2                                             | ** ** | **7.8** |   | 24.5 |   |
| Asbestos  administration                                                                                     | ** ** | **(2.7**                                         | **)**      | (2.1                                            | )          | **(8.1** | **)** | (6.4 | ) |
| COLI income, net                                                                                             | ** ** | **0.5**                                          |       | (0.3                                            | )          | **2.2** |   | 1.6 |   |
| D&O  insurance cost—portion related to Chapter 11                                              | ** ** | **(1.5**                                         | **)**      | (1.2                                            | )          | **(4.5** | **)** | (4.2 | ) |
| Pension and  postretirement benefit costs—divested businesses                                           | ** ** | **(1.9**                                         | **)**      | (0.9                                            | )          | **(5.9** | **)** | (3.5 | ) |
| Translation  effects—intercompany loan                                                                  | ** ** | **2.4**                                          |       | (1.1                                            | )          | **16.1** |   | (32.5 | ) |
| Value of  currency contracts                                                                                 | ** ** | **(1.6**                                         | **)**      | 1.1                                             | ** ** | **(15.1** | **)** | 32.3 |   |
| Net gain on sale  of real estate                                                                             | ** ** | **—**                                       |       | —                                          | ** ** | **5.0** |   | — |   |
| Stock  appreciation rights                                                                                   | ** ** | **(0.4**                                         | **)**      | —                                          | ** ** | **(2.4** | **)** | — |   |
| Legal defense  costs                                                                                         | ** ** | **(21.0**                                        | **)**      | (5.5                                            | )          | **(48.9** | **)** | (14.5 | ) |
| Other                                                                                                        | ** ** | **(0.7**                                         | **)**      | (1.9                                            | )          | **(5.1** | **)** | — |   |
| **Total**                                                                                                    | ** ** | **$**                                            | **(26.0**  | **)**                                           | $          | (7.7 | ) | **$** | **(88.9** | **)** | $ | (2.7 | ) |

 

Changes to pre-taxincome (loss) from noncore activities were attributable primarily to:

·                  Increasesin legal defense costs of $15.5 million and $34.4 million for thethree months and nine months ended September 30, 2006, respectively,compared to the prior year periods, primarily related to the Montana legalproceeding (see Note 12 to the Consolidated Financial Statements for more information),

·                  A$30.0 million increase in estimated costs in the 2006 periods forenvironmental remediation primarily in Montana (see Note 12 to the ConsolidatedFinancial Statements for more information), and

·                  $24.5 millionreceived from insurance carriers in the 2005 periods with respect to coveragefor past environmental remediation costs and asbestos-related liability underliquidation arrangements or dispute settlements, as compared with $7.8 millionin the first nine months of 2006.

InMarch 2004, we began accounting for currency fluctuations on a €293 millionintercompany loan between our subsidiaries in the United States and Germany asa component of operating results instead of as a component of othercomprehensive income. This change was prompted by an analysis of new tax lawsin Germany and our cash flow planning in connection with our Chapter 11reorganization, which together indicated that we should no longer consider thisloan as part of our permanent capital structure in Germany. In May 2004, weentered into a series of foreign currency forward contracts with a U.S. bank tomitigate future currency fluctuations on the remaining loan balance. Contractamounts of €200.7 million were extended in June 2005 at varying rates andhave terms that coincide with loan repayments due periodically through December 2008.  As part of the contract extension, we wererequired to pay a settlement premium of $9.3 million to the bank. Weexpect to recover this settlement premium over time as the contracts aresettled at rates greater than the initial rates in the May 2004 foreigncurrency forward contracts.  For the ninemonths ended September 30, 2006, €47.6 million of loan principal wasrepaid. For the three months and nine months ended September 30, 2006,respectively, $1.6 million and $15.1 million of contract losses wererecognized, offset by foreign currency gains of $2.4 million and $16.1 million.  For the three months and nine months endedSeptember 30, 2005, respectively, $1.1 million and $32.3 millionof contract gains were recognized, offset by foreign currency losses of $1.1 millionand $32.5 million.

***Chapter 11 Expenses***—Although weare unable to measure precisely the impact of the Chapter 11 proceedingson our overall financial performance, we incur significant added costs that aredirectly attributable to operating in Chapter 11. Net Chapter 11expenses consist primarily of legal, financial and consulting fees that we, thethree creditors’ committees and the representative of future asbestosclaimants, incur. These costs fluctuate with the activity in our Chapter 11proceedings.

 

I-35

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Our pre-tax incomefrom core operations included expenses for Chapter 11-related compensationcharges of $6.8 million and $4.5 million for the three months ended September30, 2006 and 2005, respectively, and $16.2 million and $13.9 million for thenine months ended September 30, 2006 and 2005, respectively.

**Weincur numerous other indirect costs to manage the Chapter 11 proceedings suchas: management time devoted to Chapter 11 matters; added cost of debt capital;added costs of general business insurance, including D&O liabilityinsurance premiums; and lost business and acquisition opportunities due to thecomplexities and restrictions of operating under Chapter 11.**

***Interest******Expense***—Net interest expense is higherfor the three months and nine months ended September 30, 2006 compared with theprior year periods due to a higher rate of interest to which general unsecuredcreditors would be entitled under the plan of reorganization. The plan ofreorganization states that each holder of an allowed general unsecured claimshall be paid in full, pluspost-petition interest. Post-petitioninterest shall accrue through the date of payment as follows:

·                  Forthe holders of pre-petition bank credit facilities, beginning January 1, 2006,we have agreed to pay interest on pre-petition bank debt at the prime ratequoted by Bloomberg, adjusted for periodic changes, and compounded quarterly.The effective rates for the three months and nine months ended September 30,2006 were 8.25% and 7.86%, respectively. From April 2, 2001, the voluntary bankruptcy filing date, throughDecember 31, 2005, we accrued interest on pre-petition bank debt at anegotiated fixed annual rate of 6.09%, compounded quarterly.

·                  Forthe holders of claims who, but for the Chapter 11 filing, would be entitledunder a contract or otherwise to accrue or be paid interest on such claim in anon-default (or non-overdue payment) situation under applicable non-bankruptcylaw, the rate provided in the contract between the Grace entity and theclaimant or such rate as may otherwise apply under applicable non-bankruptcylaw.

·                  Forall other holders of allowed general unsecured claims, at a rate of 4.19% perannum, compounded annually.

Such interest,which under the plan of reorganization is payable 85% in cash and 15% in Gracecommon stock, will not be paid until the plan of reorganization is confirmedand funded.

***Income Taxes***—In the third quarter of 2006, we reached a resolution with taxingauthorities in the United States concerning a tax position that was the subjectof dispute.  Also in the third quarter,the German legislature issued a clarification of a new tax law that will permitus to continue to receive the benefit of interest deductions on an intercompanyloan that the new law would have otherwise prohibited.  We recorded a $12.0 million reduction in thethird quarter tax expense to account for the resolution of these tax matters.  In the third quarter of 2005, we reached anagreement with the IRS on a number of tax matters, and reduced our taxliabilities and tax provision by $16.0 million. Excluding these adjustments and non-deductible Chapter 11 expenses, theeffective tax rate for the three and nine months ended September 30, 2006 and2005 was approximately 35% on consolidated taxable income.

**Operating Segment Overview**

The following is an overview of financial measures of the performance ofour operating segments for the three months and nine months ended September 30,2006, as compared with the prior year periods.

***Grace Davison***

***Three Months Ended September 30, 2006***
| *** ***                                               | ** ** | **Three Months Ended September 30,** | ** ** |
|------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| **Net Sales by Region***(In millions)* | **2006**   | ** **                                               | **2005**   | ** ** | **$ Change  Fav  (Unfav)** | ** ** | **% Change  Fav  (Unfav)** | ** ** |
|                                                       |       |                                                     |       |   |   |   |   |   |   |
| North America                                              | ** ** | **$**                                                    | **147.0**  |   | $ | 131.3 |   | $ | 15.7 |   | 12.0 | % |
| Europe                                                     | ** ** | **168.9**                                                |       | 135.0 |   | 33.9 |   | 25.1 | % |
| Asia Pacific                                               | ** ** | **65.9**                                                 |       | 56.3 |   | 9.6 |   | 17.1 | % |
| Latin America                                              | ** ** | **14.7**                                                 |       | 15.7 |   | (1.0 | ) | (6.4 | %) |
| **Total Grace Davison**                                    | ** ** | **$**                                                    | **396.5**  |   | $ | 338.3 |   | $ | 58.2 |   | 17.2 | % |

 

*Sales*

The key factors contributing to Grace Davison’ssales increase were:

·                  Recoveryin demand for refining catalysts, which was adversely affected in the third andfourth quarters of 2005 by the Gulf hurricanes;

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·                  Sellingprice increases implemented earlier in 2006 to partially offset natural gas andraw material cost inflation;

·                  Highervolume of specialty materials and catalysts in all geographic regions fromstronger economic activity and from strategic investments in products used inpharmaceutical applications; and

·                  Arecent acquisition of polyolefin catalyst capacity and technology.

Overallsales were up across all major product lines due to strong demand from highlevels of economic activity.

*Pre-tax Operating Income*

Theincrease in Grace Davison’s 2006 pre-tax operating income was attributable tohigher sales volume, higher selling prices partially offset by the negative effectsof higher raw material and energy costs, lower operating expenses as apercentage of sales and the recovery from the Gulf hurricanes. We report 100%of sales for the Advanced Refining Technologies LLC joint venture, but onlyaccount for 55% of the income in our measure of operating performance.

***Nine monthsEnded September 30, 2006***
| ** **                                                       | ** ** | **Nine Months Ended September 30,** | ** **  |
|------------------------------------------------------------------|------------|---------------------------------------------------------|-------------|
| **Net Sales by Region**

***(In millions)*** | ** ** | **2006**                                                | ** **  | **2005** | ** ** | **$ Change  Fav  (Unfav)** | ** ** | **% Change  Fav  (Unfav)** | ** ** |
| * *                                                         |       |                                                    |        |   |   |   |   |   |   |
| North America                                                    | ** ** | **$**                                                   | **409.5**   |   | $ | 388.9 |   | $ | 20.6 |   | 5.3 | % |
| Europe                                                           | ** ** | **476.7**                                               |        | 415.4 |   | 61.3 |   | 14.8 | % |
| Asia Pacific                                                     | ** ** | **205.8**                                               |        | 181.3 |   | 24.5 |   | 13.5 | % |
| Latin America                                                    | ** ** | **41.2**                                                |        | 46.3 |   | (5.1 | ) | (11.0 | %) |
| **Total Grace Davison**                                          | ** ** | **$**                                                   | **1,133.2** |   | $ | 1,031.9 |   | $ | 101.3 |   | 9.8 | % |

 

*Sales*

Sales increasesfor the nine months ended September 30, 2006 reflected similar economicconditions and cost factors as those experienced in the three months endedSeptember 30, 2006, with the exception of sales in North America.  Sales in this region were negatively affectedduring the quarter ended March 31, 2006 by continued shutdowns of severalpetroleum refineries from the Gulf hurricanes and for preventive maintenance atcustomer sites.

*Pre-tax Operating Income*

The increase in operatingincome for the nine months ended September 30, 2006 was a result of highervolume and selling prices in all geographic regions and across all productgroups and the recovery from the Gulf hurricanes, partially offset by thenegative effects of higher raw material and energy costs.

***Grace Performance Chemicals***

***Three Months Ended September 30,2006***
| ** **                                                   | ** ** | **Three Months Ended September 30,** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| **Net Sales by  Region**

***(In millions)*** | ** ** | **2006**                                                 | ** ** | **2005** | ** ** | **$ Change  Fav  (Unfav)** | ** ** | **%Change  Fav  (Unfav)** | ** ** |
| * *                                                     |       |                                                     |       |   |   |   |   |   |   |
| North America                                                | ** ** | **$**                                                    | **160.7**  |   | $ | 153.7 |   | $ | 7.0 |   | 4.6 | % |
| Europe                                                       | ** ** | **112.3**                                                |       | 97.5 |   | 14.8 |   | 15.2 | % |
| Asia Pacific                                                 | ** ** | **47.8**                                                 |       | 42.6 |   | 5.2 |   | 12.2 | % |
| Latin America                                                | ** ** | **24.1**                                                 |       | 21.3 |   | 2.8 |   | 13.1 | % |
| **Total Grace Performance  Chemicals**                       | ** ** | **$**                                                    | **344.9**  |   | $ | 315.1 |   | $ | 29.8 |   | 9.5 | % |

* *

*Sales*

The key factorscontributing to Grace Performance Chemicals’ sales increase were:

·                  Growthin commercial construction activity, particularly in Europe and Asia;

·                  Addeddistribution channels for residential building materials in the United States,which more than offset softness in new residential construction activity; and

·                  Expandeduse of new product technologies worldwide.

Sales growth was strongin all regions, reflecting the above factors, as well as geographic expansioninitiatives.

*Pre-taxOperating Income*

The increase in GracePerformance Chemicals’ 2006 operating income was primarily a result of salesvolume growth as described above, selling price increases and productivity andcost containment initiatives, partially offset by raw material cost inflation.

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***Nine months Ended September 30, 2006***
| ** **                               | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------|------------|---------------------------------------------------------|------------|
| **Net Sales by  Region***(In  millions)* | ** ** | **2006**                                                | ** ** | **2005** | ** ** | **$ Change  Fav  (Unfav)** | ** ** | **% Change  Fav  (Unfav)** | ** ** |
| North America                            | ** ** | **$**                                                   | **471.1**  |   | $ | 437.2 |   | $ | 33.9 |   | 7.8 | % |
| Europe                                   | ** ** | **320.5**                                               |       | 283.0 |   | 37.5 |   | 13.3 | % |
| Asia Pacific                             | ** ** | **134.6**                                               |       | 123.3 |   | 11.3 |   | 9.2 | % |
| Latin America                            | ** ** | **69.7**                                                |       | 57.7 |   | 12.0 |   | 20.8 | % |
| **Total Grace Performance Chemicals**    | ** ** | **$**                                                   | **995.9**  |   | $ | 901.2 |   | $ | 94.7 |   | 10.5 | % |

*Sales*

Sales increases for thenine months ended September 30, 2006 reflected similar economic conditions andresults from internal programs as in the three months ended September 30, 2006,augmented by stronger residential construction activity in the first half ofthe year.

*Pre-taxOperating Income*

The increase inoperating income for the nine months ended September 30, 2006 was a result ofthe sales increases described above, as well as positive results fromproductivity and cost containment initiatives, partially offset by raw materialcost inflation.

***Operating Returns on Assets Employed***—Thefollowing tables set forth the Grace Davison and Grace Performance Chemicalstotal asset position and pre-tax return on average total assets as of September30, 2006 and December 31, 2005.  We usethe measure pre-tax return on average total assets as an indicator of ourefficiency in using our assets and allocating our resources to generateearnings.  We devote significantly highercapital to the manufacture of Grace Davison products than to the manufacture ofGrace Performance Chemicals products. Conversely, non-manufacturing costs,particularly selling expenses, are significantly higher for Grace PerformanceChemicals than for Grace Davison.
| **Grace Davison**

***(In millions)*** | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Trade receivables                                | ** ** | **$**                        | **223.8**  |                        | $          | 178.2 |   |
| Inventory                                        | ** ** | **192.2**                    |       | 177.6                       |       |
| Other current assets                             | ** ** | **17.2**                     |       | 24.3                        |       |
| Total current assets                             | ** ** | **433.2**                    |       | 380.1                       |       |
| Properties and  equipment, net                   | ** ** | **394.6**                    |       | 390.7                       |       |
| Goodwill and other  intangible assets            | ** ** | **108.5**                    |       | 98.2                        |       |
| Other assets                                     | ** ** | **—**                   |       | —                      |       |
| Total assets                                     | ** ** | **$**                        | **936.3**  |                        | $          | 869.0 |   |
| Pre-tax return on average total assets           | ** ** | **18.4**                     | **%**      | 17.9                        | %          |

Grace Davison’s totalassets increased by $67.3 million in the first nine months of 2006. Theincrease primarily was due to higher trade receivables caused by increasedsales, and higher inventory in response to sales growth and seasonality.
| **Grace Performance Chemicals***(In millions)* | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Trade receivables                                             | ** ** | **$**                        | **262.0**  |                        | $          | 222.7 |   |
| Inventory                                                     | ** ** | **95.2**                     |       | 100.7                       |       |
| Other current assets                                          | ** ** | **14.1**                     |       | 15.7                        |       |
| Total current assets                                          | ** ** | **371.3**                    |       | 339.1                       |       |
| Properties and  equipment, net                                | ** ** | **239.1**                    |       | 226.4                       |       |
| Goodwill and other  intangible assets                         | ** ** | **91.2**                     |       | 93.5                        |       |
| Other assets                                                  | ** ** | **6.7**                      |       | 6.6                         |       |
| Total assets                                                  | ** ** | **$**                        | **708.3**  |                        | $          | 665.6 |   |
| Pre-tax return on average total assets                        | ** ** | **24.9**                     | **%**      | 22.4                        | %          |

 

Grace Performance Chemicals’ total assets increased by$42.7 million in the first nine months of 2006, mainly due to higher tradereceivables as a result of increased sales.

**Noncore Liabilities**

We have a number of financial exposures originatingfrom past businesses, products and events. These obligations arose fromtransactions and/or business practices that date to when Grace was a muchlarger company, when we produced products or operated businesses that are nolonger part of our revenue base, when government regulation was less stringentand when scientific knowledge with respect to such businesses and products wasmuch less advanced than today.

The followingtable summarizes our net noncore liabilities at September 30, 2006 and December31, 2005:
| **Net Noncore Liabilities***(In millions)* | ** ** | **September 30,  2006** | ** **   | **December 31,  2005** | ** ** |
|------------------------------------------------------|------------|------------------------------|--------------|-----------------------------|------------|
| Asbestos-related  liabilities                        | ** ** | **$**                        | **(1,700.0** | **)**                       | $          | (1,700.0 | ) |
| Asbestos-related  insurance receivable               | ** ** | **500.0**                    |         | 500.0                       |       |
| Asbestos-related  liability, net                     | ** ** | **(1,200.0**                 | **)**        | (1,200.0                    | )          |
| Environmental  remediation                           | ** ** | **(363.2**                   | **)**        | (342.0                      | )          |
| Postretirement benefits                              | ** ** | **(86.4**                    | **)**        | (101.3                      | )          |
| Income taxes                                         | ** ** | **(133.7**                   | **)**        | (136.5                      | )          |
| Retained obligations  and other                      | ** ** | **(20.1**                    | **)**        | (23.4                       | )          |
| **Net noncore liability**                            | ** ** | **$**                        | **(1,803.4** | **)**                       | $          | (1,803.2 | ) |

 

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The resolution of most ofthese noncore recorded liabilities and contingent liabilities will bedetermined through the Chapter 11 proceedings. We cannot predict with anycertainty how, and for what amounts, any of these contingencies will be resolved.The amounts of these liabilities as ultimately determined through the Chapter11 proceedings could be materially different from amounts recorded at September30, 2006.

**Plan of Reorganization**

As described under“Voluntary Bankruptcy Filing” in Notes 1 and 2 to the Consolidated FinancialStatements, Grace and our principal U.S. operating subsidiary aredebtors-in-possession under Chapter 11 of the bankruptcy code. Our non-U.S.subsidiaries, although not part of the Chapter 11 filing, are owned directly orindirectly by our principal operating subsidiary or other filing entities.Consequently, we expect that any Chapter 11 plan of reorganization, includingour proposed plan of reorganization, will involve the combined value of ourglobal businesses and other assets to fund (with cash and/or securities) ourobligations as adjudicated through the bankruptcy process. We have analyzed ourcash flow and capital needs to continue to fund our businesses and believethat, while in Chapter 11, sufficient cash flow and credit facilities areavailable to support our business strategy.

**On January 13, 2005, we filed aplan of reorganization and related documents that amended our original plan ofreorganization and disclosure statement filed on November 13, 2004 to addresscertain objections of creditors and other interested parties. The plan ofreorganization is supported by committees representing general unsecuredcreditors and equity holders, but is not supported by committees representingasbestos personal injury claimants and asbestos property damage claimants orthe representative of future asbestos claimants.  See Note 2 to the Consolidated FinancialStatements for more information on the plan of reorganization.**

***Risks of the planof reorganization***—We intend to address all pending and future asbestos-related claims andall other pre-petition claims as outlined in the plan of reorganization.However, we may not be successful in obtaining approval of the plan ofreorganization by the bankruptcy court. Instead, a materially different plan of reorganization may ultimately beapproved and, under the ultimate plan of reorganization, the interests of our shareholderscould be substantially diluted or cancelled. The value of Grace common stockfollowing a plan of reorganization, and the extent of any recovery bynon-asbestos-related creditors, will depend principally on the allowed value ofour asbestos-related claims as determined by the bankruptcy court.

Our proposed planof reorganization assumes several fundamental conditions including that:

·                  Ourasbestos-related liabilities can be resolved at a net present value cost of nomore than $1,700 million (including $87 million for pre-petitionasbestos-related contractual settlements and judgments), including all propertydamage claims (including claims related to our former Zonolite AtticInsulation, or ZAI, product) and all pending and future personal injury claims;and

·                  Thebenefit of assets from litigation settlement agreements with Sealed AirCorporation and its subsidiary, Cryovac, Inc., and Fresenius Medical CareHoldings, Inc. will be available to satisfy liabilities under the plan ofreorganization.

There can be noguarantee that these two fundamental conditions can be met. The measure of ourasbestos-related liabilities could be settled by the bankruptcy court (inconformity with the plan of reorganization or otherwise), by a negotiation withinterested parties, and/or by legislation for the personal injury component ofthis contingency.

In May 2005, theU.S. Senate Judiciary Committee reported the Specter-Leahy Fairness in AsbestosInjury Resolution Act of 2005, or FAIR, to the U.S. Senate. The FAIR bill isintended to create a fair and efficient system to resolve claims of victims forpersonal injury caused by asbestos exposure. FAIR, as reported, provides forthe creation of a government-administered trust, to be funded by payments frominsurers and defendant companies. It also includes medical criteria againstwhich monetary values have been assigned so that people with anasbestos-related condition will receive compensation under a no-fault system.

Under the currentversion of FAIR, our required payments to the fund would be approximately $30.4million payable annually over a period of up to 30 years.

Whether FAIR, asreported or as it may be amended, is enacted into law is highly uncertain.Legislation to provide a resolution for asbestos personal injury mass tortlitigation has been considered many times before and in no instance haslegislation passed both houses of Congress. A resolution of personal injuryclaims based on FAIR

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may not satisfythe conditions precedent under the litigation settlement agreements with SealedAir and Fresenius and, therefore, may reduce or eliminate the availability ofthose assets to fund a plan of reorganization.

Any resolution, otherthan that reflected in the plan of reorganization, could have a materialadverse effect on the percentage of Grace common stock to be retained by our currentshareholders beyond that reflected in the proforma financial informationpresented below. We will adjust our financial statements and the proformaeffects of the plan of reorganization as facts and circumstances warrant.

***Proforma Financial Information***—The planof reorganization, as described above, contains certain assumptions that canonly be confirmed with certainty at, or near, its effective date.  The unaudited proforma financial informationpresented below reflects the accounting effects of our proposed plan ofreorganization (1) as if it were put in effect on the date of our most recentconsolidated balance sheet, September 30, 2006, and (2) as if it were in effectfor (a) the full year ended December 31, 2005, and (b) the nine months endedSeptember 30, 2006. Proforma adjustments for tax effects have been applied at a35% tax rate.  The proforma financialinformation included herein, may not be consistent with the plan ofreorganization documents filed on January 13, 2005 due to subsequent changes inoperations and accounting estimates. Such proforma financial statements reflecthow our assets, liabilities, equity and income would be affected by the plan ofreorganization as follows:

A.                 Borrowings UnderNew Debt Agreements and Contingencies

The plan of reorganization reflects the assumptionthat $1,000 million in debt financing will be available to fund settled claimspayable at the effective date of the plan of reorganization (approximately $800million) and to provide working capital (approximately $200 million) forcontinuing operations. No such financing currently exists but, we expect, basedon discussions with prospective lenders, our sustained level of core operationswhile we have operated under Chapter 11, and publicly available informationregarding funding available to comparable companies, that we could obtainfinancing at this level before the plan of reorganization is effective. Inaddition, the proforma financial information reflects $150 million incontingencies to pay professional and bank fees, other non-operating liabilitiesand their related tax effects that will not become liabilities until theeffective date of the plan of reorganization. The $26.3 million adjustment toincrease deferred taxes reflects the tax impact on $150 million incontingencies as described above, of which we estimate 50% would be deductiblefor tax purposes. Proforma adjustments related to the borrowings under new debtfinancing and contingencies have been denoted by the capital letter **“A”** in the proforma balance sheet presentedbelow.

B.                   Freseniusand Sealed Air Settlements

The plan of reorganization reflects the value, in theform of cash and securities, expected to be realized under litigationsettlement agreements as follows: $115.0 million of cash from Fresenius; and,$1,114.5 million of estimated value from Cryovac, Inc., a subsidiary of SealedAir (calculated as of September 30, 2006) in the form of $512.5 million of cashplus accrued interest at 5.5% from December 21, 2002 compounded annually(approximately $114.9 million), and nine million shares of Sealed Air commonstock valued at $54.12 per share (approximately $487.1 million). Tax accountshave been adjusted to reflect the satisfaction of our recorded liabilities byway of these third-party agreements. The Fresenius settlement amount will bepayable directly to Grace and will be accounted for as income; however, we havepresented the amount of the settlement as a proforma balance sheet adjustmentonly in order to avoid distorting the predictive value of the proformastatement of operations with this one-time gain. Payments under the Sealed Airsettlement will be paid directly to the asbestos trust by Cryovac and will beaccounted for as satisfaction of a portion of our recorded asbestos-relatedliability and a credit to shareholder’s equity. In addition, the valuationallowance related to our federal deferred tax assets will not be required as aresult of these settlements and has therefore been reversed. Both the SealedAir and Fresenius settlements are subject to the fulfillment of specifiedconditions. The $(40.3) million adjustment to deferred income taxes in theproforma balance sheet below represents the tax impact of the $115.0 millionFresenius settlement.  The $(342.1)million adjustment to deferred income taxes represents the tax impact of the$1,114.5 Sealed Air settlement, less a $48.0 million

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adjustment to reverse the deferred tax asset valuationallowance. Proforma adjustments related to the Fresenius and Sealed Airsettlements have been denoted by the capital letter **“B”** in the proforma balance sheet presented below.

C.      Payment of Pre-Petition Liabilities

The plan ofreorganization reflects the transfer of funds and securities to settleestimated obligations payable under the plan of reorganization at the effectivedate. We would be required to issue approximately 40.8 million shares of Gracecommon stock, based on the closing price per share of $13.26 on September 30,2006, for total proceeds of $540.4 million, and utilize cash of $1,054.6million to settle these estimated obligations (see the adjustments denoted bythe capital letter **“C”** in theproforma balance sheet below).  We haveadjusted tax accounts to reflect the change in the nature of our tax assetsfrom predominately temporary differences to predominately time-limited tax netoperating losses for the payment of tax-deductible obligations such as asbestosclaims and environmental claims (see the adjustments denoted by the capitalletter **“D”** in the proforma balance sheet below).We have assumed non-asbestos pass-through liabilities will be paid in cash whendue.  A portion of the funding requiredto meet our emergence obligations will involve repatriating monies through adividend from certain non-U.S. subsidiaries. We believe that the reserve related to repatriation of funds presentlyrecorded will be adequate to absorb the U.S. tax effects of this dividend,assuming that we employ certain tax planning strategies to preserve our netoperating losses.

The followingtable presents a more detailed description of the proforma tax effects on ourdeferred tax assets related to net operating losses and temporary differences,net of valuation allowance of 1) the payment of pre-petition liabilities, 2)the Fresenius/Sealed Air payments, and 3) the structuring of emergencefinancing and receipt of dividends.
| **Summary of  Change in Deferred Tax Asset Balances***(In millions)* | ** ** | **Tax Effects of   Net Operating  Loss Carry-  Forwards** | ** ** | **Temporary  Differences, Net  of Valuation  Allowance** | ** ** |
|---------------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| **September  30, 2006 Balance As Reported**                               |       | $                                                                   | 39.4       |                                                               | $          | 697.8 |   |
| ** **                                                                | ** ** | ** **                                                          | ** ** | ** **                                                         | ** ** |
| **Proforma  Adjustments**:                                                |       |                                                                |       |                                                               |       |
| Contingent  liabilities                                                   |       | —                                                              |       | 26.3                                                               |       |
| Fresenius  payment                                                        |       | (40.3                                                               | )          | —                                                             |       |
| Sealed Air  payment                                                       |       | —                                                              |       | (342.1                                                             | )          |
| ** **                                                                | ** ** | ** **                                                          | ** ** | ** **                                                         | ** ** |
| **Emergence  Payments & Other:**                                      |       |                                                                |       |                                                               |       |
| Accrued interest                                                          |       | 53.2                                                                |       | (53.2                                                              | )          |
| Asbestos claims                                                           |       | 159.4                                                               |       | (159.4                                                             | )          |
| Environmental  claims                                                     |       | 86.2                                                                |       | (86.2                                                              | )          |
| Special pensions                                                          |       | 4.5                                                                 |       | (4.5                                                               | )          |
| Insurance  recovery                                                       |       | (175.0                                                              | )          | 175.0                                                              |       |
| Repatriation of  foreign earnings                                         |       | (70.0                                                               | )          | 70.0                                                               |       |
| Other                                                                     |       | 41.0                                                                |       | (41.0                                                              | )          |
| Subtotal                                                                  |       | 99.3                                                                |       | (99.3                                                              | )          |
|                                                                      |       |                                                                |       |                                                               |       |
| **September 30, 2006 Proforma  Balance**                                  |       | $                                                                   | 98.4       |                                                               | $          | 282.7 |   |

 

D.                  Proforma Consolidated Statement of Operations andCapital Structure

The proformaincome adjustments to our September 30, 2006 and December 31, 2005 ConsolidatedStatements of Operations consist of:

·                  The elimination of all recorded chargesand expenses directly related to Chapter 11, as these costs would be eliminatedupon effectiveness of the Plan, and the elimination of provisions recorded forenvironmental remediation obligations as we expect this risk would be resolvedunder the Plan (these eliminations are denoted by the capital letter **“E”** in the proforma statements ofoperations below);

·                  Adjustments to reduce Selling, Generaland Administrative expenses andOther Income to eliminate noncore legal expenses, and noncoreinsurance income related to asbestos litigation, as the liabilities to whichthese noncore activities relate would be settled as part of the Plan (theseadjustments are denoted by the letter **“F”**in the proforma statements of operations below);

·                  The elimination of interest expenseassociated with pre-petition bank debt, and the addition of interest expenseassociated with the new $1,000.0 million in financing as discussed above, whichresults in the net increase in interest expense denoted by the

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adjustments markedby the letter **“G”** in the proformastatements of operations below;

·                  The tax effects of the proformastatements of operations adjustments at our effective tax rate (see theadjustments denoted by the capital letter **“H”**in the proforma statements of operations below); and

·                  The addition of new shares of Gracecommon stock related to the assumed financing of the plan of reorganization(see the adjustments denoted by the capital letter **“I”** in the proforma statements of operations below).

Proforma expenses reflect an assumed 7.4% averageinterest rate on outstanding borrowings, based on market conditions as ofSeptember 30, 2006. A hypothetical 1/8 percent variance in interest rates wouldincrease or decrease our proforma net income (loss) by approximately $0.7million and $0.5 million for the full year 2005 and the nine months endedSeptember 30, 2006, respectively. 

For purposes of proforma earnings per share andproforma share capital, we used the trading price of $13.26 per share as ofSeptember 30, 2006 for calculating issued and outstanding shares. At this pershare valuation, we assume that 40.8 million shares will be issued at theeffective date of the plan of reorganization to fund asbestos and generalunsecured claims, 9.8 million shares would be issuable upon exercise ofwarrants to satisfy our estimate of PI-AO claims, and 1.8 million shares wouldbe issued upon exercise of in-the-money stock options. We present the tradingvalue solely to show proforma Consolidated Statements of Operations. Thistrading value may not be indicative of the actual trading value of Grace commonstock following the effective date of the plan of reorganization.  If our distributable value per share at theeffective date of the plan of reorganization is below approximately $7.70 pershare, we would be required to revalue our balance sheet for a change incontrol. (The trading value of Grace common stock over the twelve-month periodended September 30, 2006 was between $6.75 and $17.49 per share.) Theseproforma financial statements reflect no change in assets or income related tothis potential accounting outcome.

E.                     Non-asbestosContingencies

The accompanying proforma financial informationassumes all non-asbestos related contingencies (including environmental, taxand civil and criminal litigation) are settled for recorded amounts as ofSeptember 30, 2006.  Certain liabilitiesare assumed to be paid at the effective date of the plan of reorganization basedon our estimate of amounts that will be determinable and payable. Theremainder, which would also be subject to the plan of reorganization, ifapproved, is assumed to be paid subsequent to the effective date of the plan ofreorganization as amounts are either not due until a later date or will bedetermined through post-effective-date litigation. The ultimate value of such claimsmay change materially as Chapter 11 and other legal proceedings further defineour non-asbestos related obligations.

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### **W. R. Grace & Co and SubsidiariesProforma Condensed Consolidated Balance Sheet*****(In millions)*

 
| ** **                                                                      | ** ** | ** **                                     | ** ** | **Proforma Adjustments**                                        | ** **        | ** **                             | ** **        |
|---------------------------------------------------------------------------------|------------|------------------------------------------------|------------|----------------------------------------------------------------------|-------------------|----------------------------------------|-------------------|
| ** **                                                                      | ** ** | **September 30,  2006  As Reported** | ** ** | **Borrowings  Under  New Debt  Agreements  and  Contingencies** | ** **        | **Sealed  Air/Fresenius  Settlements** | ** **        | **Payment of  Pre-Petition  Liabilities** | ** ** | **September 30,  2006  Proforma** | ** ** |
| **ASSETS**                                                                      | ** ** | ** **                                     |       |                                                                 |              | ** **                             | ** **        |   |   |   |   |
| **Current Assets**                                                              |       |                                           |       |                                                                 |              | ** **                             |              |   |   |   |   |
| Cash and cash  equivalents                                                      |       | $                                              | 453.7      |                                                                 | $                 | 800.0                                  | **  A** | $ | 115.0 | **  B** | $ | (1,054.6 | ) **C** | $ | 314.1 |   |
| Other current assets                                                            |       | 859.5                                          |       | —                                                               |              | —                                 | ** **        | — |   | 859.5 |   |
| **Total  Current Assets**                                                       |       | 1,313.2                                        |       | 800.0                                                                |              | 115.0                                  | ** **        | (1,054.6 | ) | 1,173.6 |   |
| Non-current operating assets                                                    |       | 1,003.4                                        |       | —                                                               |              | —                                 | ** **        | — |   | 1,003.4 |   |
| Cash value of life  insurance                                                   |       | 86.9                                           |       | —                                                               |              | —                                 | ** **        | — |   | 86.9 |   |
| Deferred income taxes:                                                          |       |                                           |       |                                                                 |              | ** **                             |              |   |   |   |   |
| Net operating loss carryforwards                                                |       | 39.4                                           |       | —                                                               |              | (40.3                                  | ) **B**      | 99.3 | **  D** | 98.4 |   |
| Temporary differences, net of valuation allowance                               |       | 697.8                                          |       | 26.3                                                                 | **  A** | (342.1                                 | ) **B**      | (99.3 | **) D** | 282.7 |   |
| Asbestos-related insurance                                                      |       | 500.0                                          |       | —                                                               |              | —                                 | ** **        | — |   | 500.0 |   |
| **Total Assets**                                                                |       | $                                              | 3,640.7    |                                                                 | $                 | 826.3                                  |              | $ | (267.4 | ) | $ | (1,054.6 | ) | $ | 3,145.0 |   |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY (DEFICIT)**                         |       |                                           |       |                                                                 |              | ** **                             |              |   |   |   |   |
| Total current liabilities                                                       |       | $                                              | 411.2      |                                                                 | $                 | —                                 |              | $ | — |   | $ | — |   | $ | 411.2 |   |
| Long-term debt                                                                  |       | 0.4                                            |       | 800.0                                                                | **  A** | —                                 |              | — |   | 800.4 |   |
| Other noncurrent liabilities                                                    |       | 561.6                                          |       | —                                                               |              | —                                 | ** **        | — |   | 561.6 |   |
| **Total Liabilities Not Subject to Compromise**                                 |       | 973.2                                          |       | 800.0                                                                |              | —                                 | ** **        | — |   | 1,773.2 |   |
| Bank debt/letters of credit/capital leases                                      |       | 725.3                                          |       | —                                                               |              | —                                 | ** **        | (723.9 | **) C** | 1.4 |   |
| Liability for asbestos-related litigation and claims                            |       | 1,700.0                                        |       | —                                                               |              | (1,114.5                               | ) **B**      | (455.5 | ) **C** | 130.0 |   |
| Liability for environmental remediation                                         |       | 363.2                                          |       | —                                                               |              | —                                 | ** **        | (246.4 | **) C** | 116.8 |   |
| Liability for postretirement health and special pensions                        |       | 175.4                                          |       | —                                                               |              | —                                 | ** **        | (12.8 | ) **C** | 162.6 |   |
| Liability for accounts payable and litigation                                   |       | 114.0                                          |       | —                                                               |              | —                                 | ** **        | (94.4 | **)  C** | 19.6 |   |
| Liability for tax claims and contingencies                                      |       | 133.7                                          |       | —                                                               |              | —                                 | ** **        | (12.0 | **)  C** | 121.7 |   |
| Other nonoperating liabilities, including plan of  reorganization contingencies |       | —                                         |       | 150.0                                                                | **  A** | —                                 |              | (50.0 | ) **C** | 100.0 |   |
| **Total Liabilities Subject to Compromise**                                     |       | 3,211.6                                        |       | 150.0                                                                |              | (1,114.5                               | )                 | (1,595.0 | ) | 652.1 |   |
| **Total Liabilities**                                                           |       | 4,184.8                                        |       | 950.0                                                                |              | (1,114.5                               | )                 | (1,595.0 | ) | 2,425.3 |   |
| **Shareholder’s Equity (Deficit)**                                         |       |                                           |       |                                                                 |              | ** **                             |              |   |   |   |   |
| Share capital                                                                   |       | 424.0                                          |       | —                                                               |              | —                                 | ** **        | 540.4 |   | 964.4 |   |
| Retained earnings and other equity items                                        |       | (968.1                                         | )          | (123.7                                                               | ) **A**      | 847.1                                  | **  B** | — | **  C** | (244.7 | ) |
| **Total Shareholders’ Equity (Deficit)**                                   |       | (544.1                                         | )          | (123.7                                                               | )                 | 847.1                                  | ** **        | 540.4 |   | 719.7 |   |
| **Total  Liabilities and Shareholders’ Equity (Deficit)**                  |       | $                                              | 3,640.7    |                                                                 | $                 | 826.3                                  |              | $ | (267.4 | ) | $ | (1,054.6 | ) | $ | 3,145.0 |   |

----

Note:                   Proforma amounts in liabilitiessubject to compromise will be reclassed to liabilities not subject tocompromise after the proposed plan is in effect.

**W. R. Grace &Co. and SubsidiariesProforma Consolidated Statements of Operations***(In millions, except per share amounts)*
| ** **                                                                                                                                |       | **Year Ended December 31, 2005** | ** ** | **Nine Month Period Ended  September 30, 2006** |              |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|--------------------------------------------------------------------------|-------------------|
| ** **                                                                                                                                | ** ** | **As Reported**                                 | ** ** | **Proforma  Adjustments**                                                | ** **        | **Proforma** | ** ** | **As Reported** | ** ** | **Proforma  Adjustments** | ** ** | **Proforma** |   |
| **Net  Sales**                                                                                                                            |       | $                                                    | 2,569.5    |                                                                     | $                 | — |   | $ | 2,569.5 |   | $ | 2,129.1 |   | $ | — |   | $ | 2,129.1 |   |
| Cost of goods  sold, exclusive of depreciation and amortization shown separately below                                                    |       | 1,689.8                                              |       | —                                                                   |              | 1,689.8 |   | 1,392.0 |   | — |   | 1,392.0 |   |
| Selling, general  and administrative expenses, exclusive of net pension expense and  depreciation and amortization shown separately below |       | 481.1                                                |       | (39.4                                                                    | ) **F**      | 441.7 |   | 418.3 |   | (65.0 | ) **F** | 353.3 | ** ** |
| Depreciation and  amortization                                                                                                            |       | 114.0                                                |       | —                                                                   |              | 114.0 |   | 85.7 |   | — |   | 85.7 |   |
| Research and  development expenses                                                                                                        |       | 59.2                                                 |       | —                                                                   |              | 59.2 |   | 46.1 |   | — |   | 46.1 |   |
| Net pension  expense                                                                                                                      |       | 71.9                                                 |       | —                                                                   |              | 71.9 |   | 47.5 |   | — |   | 47.5 |   |
| Interest expense  and related financing costs                                                                                             |       | 55.3                                                 |       | 1.6                                                                      | **  G** | 56.9 |   | 54.5 |   | (9.3 | ) **G** | 45.2 |   |
| Provision for  environmental remediation                                                                                                  |       | 25.0                                                 |       | (25.0                                                                    | ) **E**      | — |   | 30.0 |   | (30.0 | ) **E** | — |   |
| Provision for  asbestos-related litigation, net of insurance                                                                              |       | —                                               |       | —                                                                   |              | — |   | — |   | — |   | — |   |
| Other (income)  expense                                                                                                                   |       | (67.4                                                | )          | 44.5                                                                     | **  F** | (22.9 | ) | (22.1 | ) | 7.8 | **  F** | (14.3 | **)** |
| **Total  costs and expenses**                                                                                                             |       | 2,428.9                                              |       | (18.3                                                                    | )                 | 2,410.6 |   | 2,052.0 |   | (96.5 | ) | 1,955.5 |   |
| **Income  (loss) before Chapter 11 expenses, income taxes, and minority interest**                                                        |       | 140.6                                                |       | 18.3                                                                     |              | 158.9 |   | 77.1 |   | 96.5 |   | 173.6 |   |
| Chapter 11  expenses, net                                                                                                                 |       | (30.9                                                | )          | 30.9                                                                     | **  E** | — |   | (32.2 | ) | 32.2 | **  E** | — | ** ** |
| Benefit from  (provision for) income taxes                                                                                                |       | (21.3                                                | )          | (26.9                                                                    | ) **H**      | (48.2 | ) | (5.4 | ) | (34.2 | ) **H** | (39.6 | **)** |
| Minority interest  in consolidated entities                                                                                               |       | (21.1                                                | )          | —                                                                   |              | (21.1 | ) | (26.2 | ) | — |   | (26.2 | ) |
| **Net  income (loss)**                                                                                                                    |       | $                                                    | 67.3       |                                                                     | $                 | 22.3 |   | $ | 89.6 |   | $ | 13.3 |   | $ | 94.5 |   | $ | 107.8 |   |
| **Basic  earnings (loss) per share**                                                                                                      |       | $                                                    | 1.01       |                                                                     | $                 | — |   | $ | 0.82 |   | $ | 0.20 |   | $ | — |   | $ | 0.98 |   |
| Weighted average  number of basic shares                                                                                                  |       | 66.8                                                 |       | 42.6                                                                     | **  I** | 109.4 |   | 67.7 |   | 42.6 | ** I** | 110.3 | ** ** |
| **Diluted  earnings (loss) per share**                                                                                                    |       | $                                                    | 1.00       |                                                                     | $                 | — |   | $ | 0.75 |   | $ | 0.20 |   | $ | — |   | $ | 0.89 |   |
| Weighted average number  of diluted shares                                                                                                |       | 67.3                                                 |       | 52.4                                                                     | **  I** | 119.7 |   | 68.1 |   | 52.4 | **  I** | 120.5 | ** ** |

 

 

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# **FinancialCondition, Liquidity and Capital Resources**

***Chapter 11-Related Information***—SeeNote 2 to the Consolidated Financial Statements.

***Asbestos-Related Litigation***—See Note 3 to the Consolidated FinancialStatements.

***Environmental Matters***—See Note 12 to the Consolidated FinancialStatements.

***Defined Contribution Retirement Plans***—We sponsor a defined contribution retirementplan for our employees in the United States. This plan qualifies under section401(k) of the U.S. tax code. At the present time, we contribute an amount equalto 100% of employee contributions, up to 6% of an individual employee’s salaryor wages. We contributed $3.0 million and $10.9 million in the three-month andnine-month periods ended September 30, 2006, respectively, compared to $2.5million and $9.9 million in the comparable prior year periods.

***Defined BenefitPension Plans***—We sponsor defined benefit pension plansfor our employees in the United States, Canada, the United Kingdom, Australia,Germany, Italy, France, Spain, Denmark, Japan, Philippines, South Korea,Taiwan, South Africa, Brazil and Mexico and fund government sponsored programsin other countries where we operate. Certain of our sponsored plans are advance-funded and others arepay-as-you-go. The advance-funded plans are administered by trustees who directthe management of plan assets and arrange to have obligations paid when due outof a trust. The most significant advance-funded plans cover our salariedemployees in the U.S. and U.K. and employees covered by collective bargainingagreements at certain of our U.S. facilities.

The following table presents the components of netpension expense and cash contributions for the advance-funded and pay-as-you-goplans:
| **Components of Net Pension Expense**

***(In millions)*** | ** ** | **Three Months  Ended  September 30,** | ** ** | **Nine Months  Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                          | ** ** | **2006**                                         | ** ** | **2005**                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Annual pension benefits  earned                                                     | ** ** | **$**                                            | **6.2**    |                                            | $          | 5.6 |   | **$** | **18.4** |   | $ | 17.6 |   |
|                                                                                |       |                                             |       |                                            |       |   |   |   |   |
| Interest on opening  liability—advance-funded plans                            | ** ** | **16.3**                                         |       | 16.3                                            | ** ** | **48.6** |   | 48.6 |   |
| Expected return on  funded assets                                                   | ** ** | **(17.8**                                        | **)**      | (16.7                                           | )          | **(53.1** | **)** | (50.2 | ) |
| Net financing of  advance-funded plans                                              | ** ** | **(1.5**                                         | **)**      | (0.4                                            | )          | **(4.5** | **)** | (1.6 | ) |
| Interest on opening  liability—pay-as-you-go plans                             | ** ** | **2.8**                                          |       | 2.5                                             | ** ** | **8.1** |   | 7.9 |   |
| Net pension financing  costs                                                        | ** ** | **1.3**                                          |       | 2.1                                             | ** ** | **3.6** |   | 6.3 |   |
| ** **                                                                          | ** ** | ** **                                       | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Amortization of:                                                                    |       |                                             |       |                                            |       |   |   |   |   |
| Plan changes  related to prior service                                              | ** ** | **0.9**                                          |       | 1.4                                             | ** ** | **2.4** |   | 4.4 |   |
| Accumulated  differences between actual and assumed performance(1)                  | ** ** | **7.5**                                          |       | 8.2                                             | ** ** | **23.1** |   | 23.4 |   |
| Net curtailment and  settlement loss                                                | ** ** | **—**                                       |       | —                                          | ** ** | **—** |   | 2.7 |   |
| Net pension catch-up  expense                                                       | ** ** | **8.4**                                          |       | 9.6                                             | ** ** | **25.5** |   | 30.5 |   |
| **Total Net Pension Expense**                                                       | ** ** | **$**                                            | **15.9**   |                                            | $          | 17.3 | ** ** | **$** | **47.5** |   | $ | 54.4 |   |

** **
| **Cash Contributions to Defined Benefit Pension Plans**

***(In millions)*** | ** ** | **Three Months  Ended  September 30,** | ** ** | **Nine Months  Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                                      | ** ** | **2006**                                         | ** ** | **2005**                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| U.S. advance-funded plans                                                                                       | ** ** | **$**                                            | **65.1**   |                                            | $          | 15.4 | ** ** | **$** | **95.3** |   | $ | 15.4 |   |
| U.S. pay-as-you-go plans                                                                                        | ** ** | **1.3**                                          |       | 1.2                                             | ** ** | **3.9** |   | 9.5 |   |
| Foreign advance-funded plans                                                                                    | ** ** | **2.2**                                          |       | 2.3                                             | ** ** | **6.4** |   | 5.5 |   |
| Foreign pay-as-you-go plans                                                                                     | ** ** | **1.3**                                          |       | 0.7                                             | ** ** | **3.9** |   | 2.4 |   |
| **Total Cash Contributions**                                                                                    | ** ** | **$**                                            | **69.9**   |                                            | $          | 19.6 | ** ** | **$** | **109.5** |   | $ | 32.8 |   |

----

(1)                                     Primarilyrelated to return on assets, termination, mortality, and data corrections

At the December31, 2005 measurement date for the U.S. advance-funded defined benefit pensionplans, the accumulated benefit obligation, or ABO, was approximately $965million as measured under U.S. generally accepted accounting principles. TheABO is measured as the present value (using a 5.5% discount rate as of December31, 2005) of vested and non-vested benefits earned from employee service todate, based upon current salary levels. This discount rate is based on a highquality bond portfolio designed to meet the payout pattern of the pensionplans. Of the participants in the pension plans, approximately 80% are current 

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retirees oremployees of our former businesses, which skews the payout pattern to thenearer term. Assets available to fund the ABO at December 31, 2005 wereapproximately $645 million, or approximately $320 million less than themeasured obligation.

Assets available at September 30, 2006 to fund the ABO of the U.S.advance-funded defined benefit pension plans totaled approximately $715 millionup $70 million from December 31, 2005, primarily as a result of current yearcontributions. It is our intention to satisfy obligations under the pensionplans and to comply with the requirements of the Employee Retirement IncomeSecurity Act of 1974. On June 16, 2006, we obtained bankruptcy court approvalto fund minimum required payments of approximately $92 million for the periodfrom July 2006 through January 2007 for U.S. advance-funded plans.  These estimated payments reflect the impactof the Pension Protection Act of 2006, which extended the interest ratesrequired under the Pension Funding Equity Act of 2004 for plan years commencingin 2006 and 2007.  In that regard, we contributedapproximately $20 million in July 2006, approximately $45 million in September2006 and approximately $6 million in October 2006, to the trusts that hold the assetsof these pension plans. There can be no assurance that the bankruptcy courtwill continue to approve arrangements to satisfy the funding needs of thePlans. Contributions to non-U.S. plans are not subject to bankruptcy courtapproval and we intend to fund such plans based on actuarial and trusteerecommendations; $3.5 million and $10.3 million was funded during the threemonths and nine months ended September 30, 2006, respectively.

 

We expect totalpension expense for 2006 to be approximately $63 million, and benefit paymentsto retirees to aggregate approximately $96 million for all pension programs in2006.  At September 30, 2006, ourrecorded pension liability for U.S. and non-U.S. underfunded plans was $481.6million ($392.6 million included in liabilities not subject to compromise and$89.0 million related to supplemental pension benefits, included in “liabilitiessubject to compromise”) which includes the following components: (1) shortfallbetween dedicated assets and ABO of underfunded plans ($254.8 million); and (2)ABO of pay-as-you-go plans ($226.8 million).

In September 2006,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 158, “Employers’ Accounting for DefinedBenefit Pension and Other Postretirement Plans.”  SFAS No. 158 requires an employer torecognize the funded status of defined benefit pension plans and otherpostretirement benefit plans as an asset or liability in its statement offinancial position, and requires recognition in other comprehensive income ofgains or losses and prior service costs or credits arising during the periodbut which are not included as components of net periodic benefit cost.  SFAS No. 158 is effective for the year endingDecember 31, 2006.  We are not currentlyable to quantify the estimated effects of the adoption of SFAS No. 158 to ourstatement of financial position, as actual amounts will depend on year-end assumptionsand calculations.  If we had adopted SFASNo. 158 effective December 31, 2005, we estimate that, after tax effects, reportedtotal assets would have decreased by approximately $55 million, reported totalliabilities would have increased by approximately $43 million, and reportedtotal shareholders’ deficit would have increased by approximately $98million.  We do not expect the adoptionof SFAS No. 158 to have a material impact on our consolidated results ofoperations.

***Postretirement Benefits Other Than Pensions***—We provide certain health care andlife insurance benefits for retired employees, a large majority of whom areretirees of divested businesses. These plans are unfunded, and we pay the costsof benefits under these plans as they are incurred. Our share of benefits underthis program was $4.2 million and $10.7 million during the three months andnine months ended September 30, 2006, compared with $3.2 million and $8.3million during the three months and nine months ended September 30, 2005. Ourrecorded liability for postretirement benefits of $86.4 million at September30, 2006 is stated at net present value discounted at 5.5% (as discussed underDefined Benefit Pension Plans). Our proposed plan of reorganization providesfor the continuation of these benefits.

***Cash Resources and AvailableCredit Facilities***—AtSeptember 30, 2006, we had $453.7 million in 

I-45

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cash and cash equivalents and $86.9 million in net cashvalue of life insurance. In addition, we had access to committed creditfacilities in the U.S., Germany and France. In the U.S., under the $250.0 million DIP facility, $192.8 million wasavailable at September 30, 2006, net of letters of credit and holdbackprovisions. The term of the DIP facility expires April 1, 2008. InGermany, under a €10.0 million line of credit, we had access to €4.5 million atSeptember 30, 2006, net of bankers guarantees and other holdbacks. The term ofthe facility expires January 17, 2007. In France, under a €3.9 million line of credit, we had access to €3.5million at September 30, 2006, net of bankers guarantees. The term of thefacility expires May 31, 2007. We believethat these funds and credit facilities will be sufficient to finance our operationswhile in Chapter 11.

***Debt and Other Contractual Obligations***—Totaldebt outstanding at September 30, 2006 was $728.9 million, including $210.9million of accrued interest on pre-petition debt.  As a result of the Chapter 11 filing, we arenow in default on $514.4 million of pre-petition debt, which, together withaccrued interest thereon, is included in “liabilities subject to compromise” inthe accompanying Consolidated Balance Sheet as of September 30, 2006. Theautomatic stay provided under the bankruptcy code prevents our lenders fromtaking any action to collect the principal amounts as well as related accruedinterest. However, we will continue to accrue and report interest on such debtduring the Chapter 11 proceedings unless further developments lead managementto conclude that it is probable that such interest will be compromised.

See Note 12 to theConsolidated Financial Statements for a discussion of financial assurances.

**Analysis of Cash Flows**

Ournet cash flow from operating activities for the nine months ended September 30,2006 was $49.4 million, compared with $14.8 million for the prior year period.The higher cash flow is attributable to improved operating results in 2006 andthe non-recurrence of $119.7 million paid to settle tax and environmentalcontingencies in 2005. Pre-tax income from core operations before depreciationand amortization was $275.3 million, 11.6% higher than in the prior yearperiod, a result of the higher income from core operations described above.Cash used for investing activities was $95.0 million, compared with $40.3million for the prior year period, primarily reflecting capital replacementsand investments in new production capacity, and the acquisition of a customcatalyst business in June 2006.

***Cash Flow from Core Operations***—Thefollowing table presents the components of net cash flow from core operations for the nine months ended September 30,2006 and 2005.
| ** **                                               | ** ** | **Nine Months  Ended** | ** ** |
|----------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                               | ** ** | **September 30,**      | ** ** |
| **Core Operations***(In millions)*             | ** ** | **2006**                    | ** ** | **2005** | ** ** |
| **Cash  flows:**                                         | ** ** | ** **                  | ** ** | ** ** | ** ** |
| Pre-tax  operating income                                | ** ** | **$**                       | **189.6**  |   | $ | 155.4 |   |
| Depreciation and  amortization                           | ** ** | **85.7**                    |       | 91.2 |   |
| **Pre-tax  income before depreciation and amortization** | ** ** | **275.3**                   |       | 246.6 |   |
| Working capital  and other changes                       | ** ** | **(102.7**                  | **)**      | (68.0 | ) |
| **Cash  flow before investing**                          | ** ** | **172.6**                   |       | 178.6 |   |
| Capital  expenditures                                    | ** ** | **(82.5**                   | **)**      | (59.2 | ) |
| Businesses  acquired                                     | ** ** | **(20.0**                   | **)**      | (2.5 | ) |
| **Net cash flow from core  operations**                  | ** ** | **$**                       | **70.1**   |   | $ | 116.9 |   |

 

We expect tocontinue to invest excess cash flow and/or other available capital resources inour core business base. We expect that these investments are likely to be inthe form of additional plant capacity, product line extensions, geographicmarket expansions, and/or acquisitions in existing product lines.  Investments that are outside the ordinarycourse of business may be subject to bankruptcy court approval and review bythe Chapter 11 creditor committees.

***Cash Flow from Noncore Activities***—Thecash flow from our noncore activities can be volatile.******Expenditures aregenerally governed by bankruptcy court rulings and receipts are generally non-recurring.Much of the noncore spending in the past three years has been under Chapter 11first-day motions that allow us to fund postretirement benefits and requiredenvironmental remediation on Grace-owned sites. Cash inflows have been fromasbestos-related insurance recovery on pre-Chapter 11 liability payments, andunusual events.

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** **
| ** **                                      | ** ** | **Nine Months  Ended** | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|
| ** **                                      | ** ** | **September 30,**      | ** ** |
| **Noncore Activities***(In millions)* | ** ** | **2006**                    | ** ** | **2005** | ** ** |
| **Cash  flows:**                                | ** ** | ** **                  | ** ** | ** ** | ** ** |
| Pre-tax income  (loss) from noncore activities  | ** ** | **$**                       | **(88.9**  | **)** | $ | (2.7 | ) |
| Other non-cash  charges                         | ** ** | **46.2**                    |       | 12.2 |   |
| Cash spending  for:                             |       |                        |       |   |   |
| Noncore contingencies:                          |       |                        |       |   |   |
| Tax settlement                                  | ** ** | **—**                  |       | (90.0 | ) |
| Environmental settlements                       | ** ** | **—**                  |       | (29.7 | ) |
| Environmental remediation                       | ** ** | **(8.7**                    | **)**      | (4.7 | ) |
| Postretirement benefits                         | ** ** | **(10.7**                   | **)**      | (8.3 | ) |
| Retained obligations and other                  | ** ** | **(2.7**                    | **)**      | (0.7 | ) |
| **Net cash flow from noncore  activities**      | ** ** | **$**                       | **(64.8**  | **)** | $ | (123.9 | ) |

Net cash flow from core operations and net cash flowfrom noncore activities do not represent income or cash flow as defined undergenerally accepted accounting principles, and you should not consider them tobe an alternative to such measures as an indicator of our performance. Weprovide these measures so that you can distinguish the cash flows of ourcurrent business base from the cash flows of past businesses, discontinuedproducts, and corporate legacies and the effect of our Chapter 11 proceedings,and to ensure that you understand the key data that management uses to evaluateour cash flows.
| ** **                                                                                                      | ** ** | **Nine Months  Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                      | ** ** | ** **                  | ** ** | **September 30,** | ** ** |
| **Reconciliation to Consolidated Statements of Cash Flows*****(In millions)* | ** ** | **2006**                    | ** ** | **2005** | ** ** |
| Net cash flow  from core operations                                                                             | ** ** | **$**                       | **70.1**   |   | $ | 116.9 |   |
| Net cash flow  from noncore activities                                                                          | ** ** | **(64.8**                   | **)**      | (123.9 | ) |
| Cash paid for  interest, income taxes net of refunds, and Chapter 11 expenses                                   | ** ** | **(58.4**                   | **)**      | (39.9 | ) |
| Investing  activities related to life insurance and sales of assets                                             | ** ** | **7.4**                     |       | 20.9 |   |
| Financing  activities                                                                                           | ** ** | **14.5**                    |       | (8.1 | ) |
| Effect of  currency exchange rate changes on cash and cash equivalents                                          | ** ** | **10.2**                    |       | (12.8 | ) |
| Increase (decrease) in  cash and cash equivalents per Consolidated Statements of Cash Flows                     | ** ** | **$**                       | **(21.0**  | **)** | $ | (46.9 | ) |
|                                                                                                                 |            |                             |            |  |  |  |  |  |  |

See the “Consolidated Statements of Cash Flows”included in the Consolidated Financial Statements for more information.

**Forward-Looking Statements**

This documentcontains, and our other public communications may contain, forward-lookinginformation, that is, information related to future, not past, events. Suchinformation generally includes the words ‘‘believes,’’ ‘‘plans,’’ ‘‘intends,’’ ‘‘targets,’’‘‘will,’’ ‘‘expects,’’ ‘‘anticipates,’’ or similar expressions.  Forward-looking information includes allstatements regarding our Chapter 11 proceeding (including the proformafinancial statements included in ‘‘Management’s Discussion and Analysis ofFinancial Condition and Results of Operations’’); expected financial position;results of operations; cash flows; financing plans; business strategy; budgets;capital and other expenditures; competitive positions; growth opportunities forexisting products; benefits from new technology and cost reduction initiatives,plans and objectives;  and markets forsecurities. For these statements, we claim the protection of the safe harborfor forward-looking statements contained in the Private Securities LitigationReform Act of 1995. Factors that could cause actual results to materiallydiffer from those contained in the forward-looking statements include:  our bankruptcy and proposed plan ofreorganization, our legal proceedings, especially the Montana criminalproceeding and the environmental proceedings, the cost and availability of rawmaterials, especially natural gas and petroleum-based raw materials, ourunfunded pension obligations, risks related to foreign operations, especially,security, regulation and currency risks, costs of compliance with environmentalregulation and those factors set forth in our most recent Annual Report on Form10-K, this quarterly report on Form 10-Q and current reports on Form 8-K, whichhave been filed with the Securities and Exchange Commission.  Like other businesses, we are subject torisks and uncertainties that could cause our actual results to differmaterially from our projections or that could cause other forward-lookinginformation to prove incorrect. Further, our reported results should not beconsidered as an indication of our future performance. Readers are cautionednot to place undue reliance on our projections and forward-looking information,which speak only as of the date thereof. We undertake no obligation to publiclyrelease any revisions to the projections and forward-looking informationcontained in this document, or to update them to reflect events orcircumstances occurring after the date of this document.

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**Item 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

Grace’s debtobligations, its global operations, the nature of the specialty chemicals productionprocess and the industry in which it engages expose Grace to various marketrisks.  Grace utilizes derivativefinancial instruments and derivative commodity instruments to mitigate certainof its market risks.  The following is adiscussion of Grace’s primary market risk exposures, how those exposures aremanaged, and certain quantitative data pertaining to Grace’s market risksensitive instruments.

##### *Interest Rate Risk*

Interest rate fluctuations directly affect interest expense and cash tobe paid out in the form of interest payments on variable-rate debt, and canpotentially lead to changes in the market value of the associated variable-ratedebt.

 

Grace has $500 million of outstanding pre-petitionvariable-rate borrowings under bank revolving credit agreements, and interestis accrued on this debt based on the prime rate as quoted by Bloomberg (the “Primerate”).  Due to the Filing, interestaccrued on pre-petition debt is added to the principal balance.  As of September 30, 2006, total interestaccrued on this debt and added to the $500 million principal was $208.5million.  If the Prime rate were to varyin the near-term by one percentage point, the effect would be to increase ordecrease interest expense and outstanding principal by approximately $7.5million over the twelve-month period ended September 30, 2007.  

Grace also maintains a$250 million debtor-in-possession facility (DIP). The interest rate under thisfacility is based on LIBOR, a variable rate. As of September 30, 2006, no amount was outstanding under this facility,and $192.8 million was available to Grace, net of letters of credit andholdback provisions.

Grace does notcurrently use derivative instruments to attempt to mitigate its interest raterisk.

##### *Foreign Currency Exchange Rate Risk*

Because Grace doesbusiness in over 40 countries, results are exposed to fluctuations in foreignexchange rates. Grace seeks to minimize exposure to these fluctuations bymatching revenue streams in volatile currencies with expenditures in the samecurrencies, but it is not always possible to do so.  From time to time, Grace uses financialinstruments such as foreign currency forward contracts, options, orcombinations of the two to reduce the risk of certain specific transactions.However, Grace does not have a policy of hedging all exposures, becausemanagement does not believe that such a level of hedging would becost-effective, particularly translation exposures that are not expected toaffect cash flows in the near-term. Significant uses of derivatives to mitigate the effects of changes inforeign currency exchange rates are as follows:

In May 2004, Gracepurchased forward contracts with a U.S. bank to minimize currency risk relatedto a Euro-denominated intercompany loan due from a German subsidiary of Graceto a U.S. subsidiary of Grace.  In June2005, Grace extended a portion of the forward contract amounts to dates thatmature on the dates of the scheduled principal repayments.  As part of the contract extension, Grace wasrequired to pay a settlement premium of $9.3 million to the bank.  Grace expects this settlement premium will berecovered over time as the contracts are settled at rates greater than theinitial rates in the May 2004 foreign currency forward contracts.  Currency fluctuations on this loan arerecorded as a component of operating results. The loan is denominated in Euros, and the total amount outstanding underthe intercompany loan was €153.1 million as of September 30, 2006(approximately $194.1 million).

The followingtable provides information about Grace’s significant foreign currency forwardexchange agreements as of September 30, 2006, specifically, the notionalamounts and weighted average exchange rates by expected (contractual) maturitydates.  These notional amounts generallyare used to calculate the 

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contractualpayments to be exchanged under the contract. The fair values represent the fairvalue of the derivative contracts.
| ** **                                                                     | ** ** | ** ** | ** ** | **Expected Maturity Date** | ** ** |
|--------------------------------------------------------------------------------|------------|------------|------------|--------------------------------------|------------|
| **Forward  Exchange Agreements (Receive $U.S./Pay Euros)** | ** ** | **2006**   | ** ** | **2007**                             | ** ** | **2008** | ** ** | **Total** | ** ** | **Fair Value** | ** ** |
| Contract amount  (in millions of $U.S.)                                        |       | $          | 23.0       |                                 | $          | 92.8 |   | $ | 79.1 |   | $ | 194.9 |   | $ | (6.3 | ) |
| Average contractual  exchange rate, $U.S. to Euros                             |       | 1.26       |       | 1.27                                 |       | 1.28 |   | 1.27 |   | N/A |   |
|                                                                                |            |            |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Grace’s U.S. subsidiaries purchase a significant amount of productsfrom Grace Canada, and these purchases are denominated in Canadian dollars(CAD).  From time to time, Grace maypurchase foreign currency exchange rate forward contracts and/or options inorder to reduce the impact of currency exchange to Grace’s consolidated grossmargin as a result of intercompany transactions denominated in CAD.  In the third quarter of 2006, Grace U.S.purchased options to acquire CAD from a U.S. financial institution to hedgeforeign currency exposures related to intercompany purchases of products fromGrace Canada.  Grace U.S. entered intocontracts with a total notional value of 4.9 million CAD (approximately $4.4million as of September 30, 2006) and a weighted average strike price of CAD1.1063/$U.S.  All foreign currencyoptions contracts entered into as of September 30, 2006 will expire by December31, 2006.  The fair value of theseoptions at September 30, 2006 was not material.

 

The fair values of foreign currency exchange rate derivative contractsare presented as other assets or other liabilities and allocated betweencurrent and non-current, as appropriate, in the Consolidated Balance Sheets.

 

##### *Commodity Price Risk*

Grace operates inmarkets where the prices of raw materials and energy are commonly affected bycyclical movements of the economy.  Theprincipal raw materials used in Grace’s products include caustic, alumina, rareearths, nickel, aluminum, cobalt carbonate, kaolin, molybdenum, sodiumaluminate, sodium silicate, olefins, gypsum, resins, rubber and latices.  Natural gas is the largest single energysource that Grace purchases. These commodities are generally available to bepurchased from more than one supplier. In order to minimize the risk of increasing prices on its significantraw materials and energy, Grace has moved towards a centralized supply chainorganization for procurement in order to improve purchasing activities. Gracehas also formed a risk management committee to review proposals to hedgepurchases of raw materials, energy and currency.

Natural gas pricescan be volatile, as experienced during 2005 in the aftermath of HurricanesKatrina and Rita in the Gulf Coast. These disasters caused a significant increase in natural gas prices thatnegatively impacted Grace’s production costs in the third and fourth quartersof 2005.  Grace has implemented an energyrisk management program under which its goal is to hedge its natural gas supplyin a way that provides protection against the continued price volatility of thenatural gas market.  In order to mitigatevolatile natural gas prices, Grace has entered into forward contracts, fixedprice swaps and options to hedge a portion of its 2006 and 2007 natural gasrequirements.   As of September 30, 2006,Grace has not entered into any commodity derivatives to hedge raw materialprices.

The following tableprovides information about Grace’s forward contracts, swaps and options thatare sensitive to changes in commodity prices, specifically natural gasprices.  Contract volumes, or notionalamounts, are presented in millions of British thermal units (MMBtu), weightedaverage contract prices are presented in $U.S. per MMBtu, and the totalcontract amount and fair value are presented in millions of $U.S.  The fair values represent the fair value ofthe derivative contracts.  The fair valuefor swaps represents the excess of the variable price (market price) over thefixed price (pay price) multiplied by the nominal contract volumes.  The fair value of options represents theexcess of the market value amounts (as quoted on the New York MercantileExchange) over the contract amount.

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| **Type of Contract** | ** ** | ** ** | ** ** | **Contract  Volumes** | ** ** | **Maturity** | ** ** | **Weighted  Average  Price  ($US/MMBtu)** | ** ** | **Total  Contract  Amount** | ** ** | **Fair Value** | ** ** |
|--------------------------------|------------|------------|------------|-----------------------|------------|--------------|------------|-------------------------------------------|------------|-----------------------------|------------|---------------------|------------|
| Forwards                       |       | 990,000    |       | 2006                  |       | $            | 9.39       |                                      | $          | 9.3                         |       | $                   | 6.4        |   |
| Forwards                       |       | 570,000    |       | 2007                  |       | 10.56        |       | 6.0                                       |       | 4.4                         |       |
| Swaps (long).                  |       | 660,000    |       | 2007                  |       | 7.93         |       | 5.2                                       |       | (0.4                        | )          |
| Call Options (long)            |       | 200,000    |       | 2006                  |       | 10.50        |       | 2.1                                       |       | (0.3                        | )          |
|                                |            |            |            |                       |            |              |            |                                           |            |                             |            |                     |            |  |  |  |

 

The fair value of commodity swaps and options derivative contracts arepresented as other assets or other liabilities and allocated between currentand non-current, as appropriate, in the Consolidated Balance Sheets.  Grace’s forward contracts for natural gasqualify for the normal purchases and normal sales exception from SFAS No. 133,as they do not contain net settlement provisions, and result in physicaldelivery of natural gas from suppliers. Therefore, the fair values of these contracts are not recorded in Grace’sConsolidated Balance Sheets.

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**Item 4.****           CONTROLS ANDPROCEDURES**

* *

*EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES*

* *

As of September30, 2006, Grace carried out an evaluation of the effectiveness of the designand operation of its disclosure controls and procedures pursuant to Rule 13a-15under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).Based upon that evaluation, Grace’s Chief Executive Officer and Chief FinancialOfficer concluded that Grace’s disclosure controls and procedures are effectiveto ensure that information required to be disclosed in Grace’s Exchange Actreports is recorded, processed, summarized and reported within the time periodsspecified in the SEC’s rules and forms, and that material information relatingto Grace is made known to management, including Grace’s Chief Executive Officerand Chief Financial Officer, as appropriate to allow timely decisions regardingrequired disclosure.

*CHANGESIN INTERNAL CONTROL OVER FINANCIAL REPORTING*

There were nochanges in Grace’s internal control over financial reporting during the quarterended September 30, 2006 that have materially affected, or are reasonably likelyto materially affect, Grace’s internal control over financial reporting.

 

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**PART II.  OTHER INFORMATION**

**Item 1.**                          LEGALPROCEEDINGS

Notes 2, 3 and 12 to the interim consolidatedfinancial statements in Part I of this Report are incorporated herein byreference.

**Item 1A.**                 RISK FACTORS

With respect tocertain risk factors disclosed in the “Risk Factors” section of our AnnualReport on Form 10-K for the year ended December 31, 2005, more recent numericalmeasures and other information are available in the “Financial Statements,” “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” and “Quantitativeand Qualitative Disclosures About Market Risk” sections of this Report.  These more recent measures and informationare incorporated herein by reference.

**Item 6.**                          EXHIBITS

The following is a list of Exhibits filed as part ofthis Quarterly Report on Form 10-Q:
| 15       | Accountants’ Awareness Letter                                                                                                            |
|----------|-----------------------------------------------------------------------------------------------------------------------------------------------|
|     |                                                                                                                                          |
| 31.(i).1 | Certification of Periodic Report by Chief Executive  Officer under Section 302 of the Sarbanes-Oxley Act of 2002                              |
|     |                                                                                                                                          |
| 31.(i).2 | Certification of Periodic Report by Chief Financial  Officer under Section 302 of the Sarbanes-Oxley Act of 2002                              |
|     |                                                                                                                                          |
| 32       | Certification of Periodic Report by Chief Executive  Officer and Chief Financial Officer under Section 906 of the Sarbanes-Oxley  Act of 2002 |

 

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**SIGNATURES**

In accordance with therequirements of the Securities Exchange Act of 1934, the Registrant caused thisReport to be signed on its behalf by the undersigned, thereunto dulyauthorized.
|                         | W. R. GRACE & CO. |
|-------------------------|-----------------------|
|                    |                  | (Registrant) |
|                    |                  |   |
|                    |                  |   |
| Date: November  8, 2006 | By                    | /s/ A. E.  FESTA |
|                    |                  | A. E. Festa |
|                    |                  | President and Chief Executive Officer |
|                    |                  |   |
|                    |                  |   |
| Date: November  8, 2006 | By                    | /s/ ROBERT M.  TAROLA |
|                    |                  | Robert M. Tarola |
|                    |                  | Senior Vice President and Chief Financial Officer  (Principal Accounting Officer) |

 

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**EXHIBIT INDEX**
| Exhibit No. | ** ** | **Description of Exhibit**                                                                                                                    |
|-------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------|
| 15          |       | Accountants’  Awareness Letter                                                                                                           |
| 31.(i).1    |       | Certification  of Periodic Report by Chief Executive Officer under Section 302 of the  Sarbanes-Oxley Act of 2002                             |
| 31.(i).2    |       | Certification  of Periodic Report by Chief Financial Officer under Section 302 of the  Sarbanes-Oxley Act of 2002                             |
| 32          |       | Certification of  Periodic Report by Chief Executive Officer and Chief Financial Officer under  Section 906 of the Sarbanes-Oxley Act of 2002 |

 

 

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