**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

** **

** **

**FORM 10-Q**

(Mark One)

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

**FOR THE QUARTERLY PERIODENDED JUNE 30, 2006**

** **

**OR**

** **

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

**Commission File Number1-13953**

** **

** **

**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 executiveoffices)

 

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (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-accelerated filer   o

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).

Yes    o                         No  x

68,258,065 shares of Common Stock, $0.01 par value,were outstanding at July 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 to I - 29  |
|          |                       |                                                                                        |       |             |
| Item 2.       |                       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations |       | I - 30 to I - 46 |
|          |                       |                                                                                        |       |             |
| Item 3.       |                       | Quantitative and Qualitative Disclosures About Market  Risk                                 |       | I - 47 to I - 48 |
|          |                       |                                                                                        |       |             |
| Item 4.       |                       | Controls and Procedures                                                                     |       | I -  49          |
|          |                       |                                                                                        |       |             |
| **Part  II.** | **Other  Information**     |                                                                                        |       |
| ** **    | ** **                 |                                                                                        |       |
| Item  1.      |                       | Legal  Proceedings                                                                          |       | II -  1          |
|          |                       |                                                                                        |       |             |
| Item 1A.      |                       | Risk Factors                                                                                |       | II -  1          |
|          |                       |                                                                                        |       |             |
| Item 6.       |                       | Exhibits                                                                                    |       | II -  1          |

 

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**PART I.  FINANCIAL INFORMATION**

**Item 1.  FINANCIAL STATEMENTS**

Review by Independent Registered Public AccountingFirm

A review of the interim consolidated financialstatements included in this Quarterly Report on Form 10-Q for the three and sixmonths ended June 30, 2006 and 2005 has been performed byPricewaterhouseCoopers LLP, the company’s independent registered publicaccounting firm. Their report on the interim consolidated financial statementsfollows.  This report is not considered a“report” within the meaning of Sections 7 and 11 of the Securities Act of 1933,and, therefore, the independent accountants’ liability under Section 11 doesnot extend to it.

I-1

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**Report of Independent Registered Public AccountingFirm**

**To the Shareholders 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 June 30, 2006, and the relatedconsolidated statements of operations, shareholders’ equity (deficit) andcomprehensive income (loss) for each of the three-month and six-month periodsended June 30, 2006 and June 30, 2005 and the consolidated statements of cashflows for the six-month periods ended June 30, 2006 and June 30, 2005. Theseinterim financial statements are the responsibility of the Company’smanagement.

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 over financialreporting and on the effectiveness of the Company’s internal control overfinancial 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  LLP |   |
|---------------------------------|--------|
| McLean, Virginia                |   |
| August 8, 2006                  |   |

 

I-2

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**W.R. Grace & Co. and SubsidiariesConsolidated Statements of Operations (Unaudited)***In millions, except pershare amounts*
| ** **                                                                                                                                | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                                                                | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net sales                                                                                                                                 | ** ** | **$**                                           | **729.1**  |                                          | $          | 676.5 | ** ** | **$** | **1,387.7** |   | $ | 1,279.7 |   |
| Cost of goods  sold, exclusive of depreciation and amortization shown separately below                                                    | ** ** | **470.2**                                       |       | 439.7                                         | ** ** | **908.2** |   | 832.4 |   |
| Selling, general  and administrative expenses, exclusive of net pension expense and  depreciation and amortization shown separately below | ** ** | **141.5**                                       |       | 117.8                                         | ** ** | **269.7** |   | 235.4 |   |
| Depreciation and  amortization                                                                                                            | ** ** | **28.4**                                        |       | 30.2                                          | ** ** | **56.5** |   | 60.7 |   |
| Research and  development expenses                                                                                                        | ** ** | **15.1**                                        |       | 15.1                                          | ** ** | **30.6** |   | 30.2 |   |
| Net pension  expense                                                                                                                      | ** ** | **16.8**                                        |       | 19.5                                          | ** ** | **31.6** |   | 37.1 |   |
| Interest expense  and related financing costs                                                                                             | ** ** | **19.9**                                        |       | 13.3                                          | ** ** | **35.7** |   | 27.9 |   |
| Provision for  environmental remediation                                                                                                  | ** ** | **30.0**                                        |       | —                                        | ** ** | **30.0** |   | — |   |
| Other (income)  expense                                                                                                                   | ** ** | **(13.9**                                       | **)**      | (23.9                                         | )          | **(15.8** | **)** | (30.0 | ) |
|                                                                                                                                      | ** ** | **708.0**                                       |       | 611.7                                         | ** ** | **1,346.5** |   | 1,193.7 |   |
| Income (loss)  before Chapter 11 expenses, income taxes, and minority interest                                             | ** ** | **21.1**                                        |       | 64.8                                          | ** ** | **41.2** |   | 86.0 |   |
| Chapter 11  expenses, net                                                                                                                 | ** ** | **(11.5**                                       | **)**      | (4.6                                          | )          | **(20.2** | **)** | (10.6 | ) |
| Benefit from  (provision for) income taxes                                                                                                | ** ** | **(3.3**                                        | **)**      | (20.0                                         | )          | **(7.8** | **)** | (28.6 | ) |
| Minority  interest in consolidated entities                                                                                               | ** ** | **(11.5**                                       | **)**      | (7.5                                          | )          | **(18.3** | **)** | (11.0 | ) |
| **Net income (loss)**                                                                                                                     | ** ** | **$**                                           | **(5.2**   | **)**                                         | $          | 32.7 | ** ** | **$** | **(5.1** | **)** | $ | 35.8 |   |
| **Basic earnings (loss) per  share:**                                                                                                     | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss)                                                                                                                         | ** ** | **$**                                           | **(0.08**  | **)**                                         | $          | 0.49 | ** ** | **$** | **(0.08** | **)** | $ | 0.54 |   |
| Weighted average number of basic shares                                                                                                   | ** ** | **67.9**                                        |       | 66.9                                          | ** ** | **67.5** |   | 66.8 |   |
| **Diluted earnings (loss) per  share:**                                                                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Net income (loss)                                                                                                                         | ** ** | **$**                                           | **(0.08**  | **)**                                         | $          | 0.49 | ** ** | **$** | **(0.08** | **)** | $ | 0.53 |   |
| Weighted average  number of diluted shares                                                                                                | ** ** | **67.9**                                        |       | 67.2                                          | ** ** | **67.5** |   | 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*
| ** **                                                                                                                                  | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                                                                  | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
| **OPERATING ACTIVITIES**                                                                                                                    | ** ** | ** **                                    | ** ** | ** ** | ** ** |
| Net income  (loss)                                                                                                                          | ** ** | **$**                                         | **(5.1**   | **)** | $ | 35.8 |   |
| Reconciliation to net  cash provided by (used for) operating activities:                                                                    |       |                                          |       |   |   |
| Chapter 11 expenses, net                                                                                                                    | ** ** | **20.2**                                      |       | 10.6 |   |
| (Benefit from) provision for income taxes                                                                                                   | ** ** | **7.8**                                       |       | 28.6 |   |
| Minority interest in consolidated entities                                                                                                  | ** ** | **18.3**                                      |       | 11.0 |   |
| Depreciation and amortization                                                                                                               | ** ** | **56.5**                                      |       | 60.7 |   |
| Interest accrued on pre-petition liabilities subject  to compromise                                                                         | ** ** | **34.7**                                      |       | 25.4 |   |
| Net (gain) loss on sales of investments and  disposals of assets                                                                            | ** ** | **(2.8**                                      | **)**      | (0.5 | ) |
| Net pension expense                                                                                                                         | ** ** | **31.6**                                      |       | 37.1 |   |
| Payments to fund defined benefit pension arrangements                                                                                       | ** ** | **(39.6**                                     | **)**      | (13.2 | ) |
| Net income from life insurance policies                                                                                                     | ** ** | **(1.7**                                      | **)**      | (1.9 | ) |
| Provision for uncollectible receivables                                                                                                     | ** ** | **0.5**                                       |       | 0.9 |   |
| Provision for environmental remediation                                                                                                     | ** ** | **30.0**                                      |       | — |   |
| Payments under postretirement benefit plans                                                                                                 | ** ** | **(6.5**                                      | **)**      | (5.1 | ) |
| Expenditures for environmental remediation                                                                                                  | ** ** | **(3.4**                                      | **)**      | (3.0 | ) |
| Expenditures for retained obligations of divested  businesses                                                                               | ** ** | **(1.3**                                      | **)**      | (0.5 | ) |
| 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)                                                        | ** ** | **(86.2**                                     | **)**      | (71.7 | ) |
| Other accruals and non-cash items                                                                                                           | ** ** | **(7.2**                                      | **)**      | (45.2 | ) |
| **Net cash provided by (used for) operating  activities before income taxes, Chapter 11 expenses and settlement of noncore  contingencies** | ** ** | **45.8**                                      |       | 69.0 |   |
| Cash paid to  settle noncore contingencies                                                                                                  | ** ** | **—**                                    |       | (119.7 | ) |
| Chapter 11  expenses paid                                                                                                                   | ** ** | **(16.9**                                     | **)**      | (9.0 | ) |
| Income taxes  paid, net of refunds                                                                                                          | ** ** | **(17.8**                                     | **)**      | (14.9 | ) |
| **Net cash provided by (used for) operating  activities**                                                                                   | ** ** | **11.1**                                      |       | (74.6 | ) |
| **INVESTING ACTIVITIES**                                                                                                                    | ** ** | ** **                                    | ** ** | ** ** | ** ** |
| Capital  expenditures                                                                                                                       | ** ** | **(51.9**                                     | **)**      | (36.8 | ) |
| 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                                                                                                  | ** ** | **(0.1**                                      | **)**      | 2.4 |   |
| Proceeds from  sales of investments and disposals of assets                                                                                 | ** ** | **7.2**                                       |       | 1.9 |   |
| **Net cash provided by (used for) investing  activities**                                                                                   | ** ** | **(64.8**                                     | **)**      | (20.2 | ) |
| **FINANCING ACTIVITIES**                                                                                                                    | ** ** | ** **                                    | ** ** | ** ** | ** ** |
| Net payments of  loans secured by cash value of life insurance policies                                                                     | ** ** | **—**                                    |       | (0.6 | ) |
| Net (repayments)  borrowings under credit arrangements                                                                                      | ** ** | **0.6**                                       |       | (1.2 | ) |
| Fees under  debtor-in-possession credit facility                                                                                            | ** ** | **(1.1**                                      | **)**      | (1.1 | ) |
| Proceeds from  exercise of stock options                                                                                                    | ** ** | **15.8**                                      |       | 3.0 |   |
| **Net cash provided by (used for) financing  activities**                                                                                   | ** ** | **15.3**                                      |       | 0.1 |   |
| Effect of  currency exchange rate changes on cash and cash equivalents                                                                      | ** ** | **6.9**                                       |       | (11.7 | ) |
| **Increase (decrease) in cash and cash equivalents**                                                                                        | ** ** | **(31.5**                                     | **)**      | (106.4 | ) |
| Cash and cash  equivalents, beginning of period                                                                                             | ** ** | **474.7**                                     |       | 510.4 |   |
| Cash and cash  equivalents, end of period                                                                                                   | ** ** | **$**                                         | **443.2**  |   | $ | 404.0 |   |

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

I-4

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**W.R. Grace & Co. and SubsidiariesConsolidated Balance Sheets (Unaudited)***In millions, except parvalue and shares*
| ****                                                                                                                                | ** ** | **June 30,  2006** | ** **  | **December 31,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|-------------|-----------------------------|------------|
| **ASSETS**                                                                                                                          |       |                    |        |                        |       |
| **Current Assets**                                                                                                                  |       |                    |        |                        |       |
| Cash and cash  equivalents                                                                                                          | ** ** | **$**                   | **443.2**   |                        | $          | 474.7 |   |
| Trade accounts  receivable, less allowance of $4.6 (2005 - $5.0)                                                                    | ** ** | **472.4**               |        | 401.7                       |       |
| Inventories                                                                                                                         | ** ** | **309.3**               |        | 278.3                       |       |
| Deferred income  taxes                                                                                                              | ** ** | **26.6**                |        | 27.3                        |       |
| Other current  assets                                                                                                               | ** ** | **54.3**                |        | 71.6                        |       |
| **Total Current Assets**                                                                                                            | ** ** | **1,305.8**             |        | 1,253.6                     |       |
| Properties and  equipment, net of accumulated depreciation and amortization of $1,476.8 (2005  - $1,420.2)                          | ** ** | **640.2**               |        | 632.9                       |       |
| Goodwill                                                                                                                            | ** ** | **103.6**               |        | 103.9                       |       |
| Cash value of  life insurance policies, net of policy loans                                                                         | ** ** | **86.6**                |        | 84.8                        |       |
| Deferred income  taxes                                                                                                              | ** ** | **726.4**               |        | 703.9                       |       |
| Asbestos-related  insurance                                                                                                         | ** ** | **500.0**               |        | 500.0                       |       |
| Other assets                                                                                                                        | ** ** | **249.1**               |        | 238.1                       |       |
| **Total Assets**                                                                                                                    | ** ** | **$**                   | **3,611.7** |                        | $          | 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                                                                                                                    | ** ** | **164.8**               |        | 166.8                       |       |
| Income taxes  payable                                                                                                               | ** ** | **16.9**                |        | 10.1                        |       |
| Other current  liabilities                                                                                                          | ** ** | **191.5**               |        | 197.9                       |       |
| **Total Current Liabilities**                                                                                                       | ** ** | **376.4**               |        | 377.1                       |       |
| Debt payable  after one year                                                                                                        | ** ** | **0.4**                 |        | 0.4                         |       |
| Deferred income  taxes                                                                                                              | ** ** | **59.9**                |        | 54.3                        |       |
| Minority  interest in consolidated affiliates                                                                                       | ** ** | **55.7**                |        | 36.4                        |       |
| Unfunded defined  benefit pension liability                                                                                         | ** ** | **445.5**               |        | 447.5                       |       |
| Other  liabilities                                                                                                                  | ** ** | **38.6**                |        | 41.7                        |       |
| **Total Liabilities Not Subject to Compromise**                                                                                     | ** ** | **976.5**               |        | 957.4                       |       |
| **Liabilities  Subject to Compromise — Note 2**                                                                                | ** ** | **3,205.6**             |        | 3,155.1                     |       |
| **Total Liabilities**                                                                                                               | ** ** | **4,182.1**             |        | 4,112.5                     |       |
| **Commitments and Contingencies**                                                                                                   | ** ** | ** **              | ** **  | ** **                  | ** ** |
| **Shareholders’ Equity (Deficit)**                                                                                             |       |                    |        |                        |       |
| Common stock  issued, par value $0.01; 300,000,000 shares authorized; outstanding: 2006 —  68,258,065 (2005 — 66,922,196) | ** ** | **0.8**                 |        | 0.8                         |       |
| Paid-in capital                                                                                                                     | ** ** | **423.2**               |        | 423.4                       |       |
| Accumulated  deficit                                                                                                                | ** ** | **(511.0**              | **)**       | (505.9                      | )          |
| Treasury stock,  at cost: shares: 2006 — 8,721,695; (2005 — 10,057,564)                                                   | ** ** | **(103.8**              | **)**       | (119.7                      | )          |
| Accumulated  other comprehensive income (loss)                                                                                      | ** ** | **(379.6**              | **)**       | (393.9                      | )          |
| **Total Shareholders’ Equity (Deficit)**                                                                                       | ** ** | **(570.4**              | **)**       | (595.3                      | )          |
| **Total  Liabilities and Shareholders’ Equity (Deficit)**                                                                      | ** ** | **$**                   | **3,611.7** |                        | $          | 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)***Inmillions*
| ** **                         | ** ** | **Common  Stock and  Paid-in  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Treasury  Stock** | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** | **Total  Shareholders’  Equity  (Deficit)** | ** ** |
|------------------------------------|------------|----------------------------------------------|------------|--------------------------|------------|---------------------|------------|-----------------------------------------------------------|------------|--------------------------------------------------|------------|
| **Balance,  March 31, 2006**       |       | $                                            | 423.5      |                     | $          | (505.8              | )          | $                                                         | (117.1     | )                                                | $          | (393.5 | ) | $ | (592.9 | ) |
| Net income  (loss)                 |       | —                                       |       | (5.2                     | )          | —              |       | —                                                    |       | (5.2                                             | )          |
| Stock plan  activity               |       | 0.5                                          |       | —                   |       | 13.3                |       | —                                                    |       | 13.8                                             |       |
| Other  comprehensive income (loss) |       | —                                       |       | —                   |       | —              |       | 13.9                                                      |       | 13.9                                             |       |
| **Balance,  June 30, 2006**        | ** ** | **$**                                        | **424.0**  | ** **               | **$**      | **(511.0**          | **)**      | **$**                                                     | **(103.8** | **)**                                            | **$**      | **(379.6** | **)** | **$** | **(570.4** | **)** |
| ** **                         | ** ** | ** **                                   | ** ** | ** **               | ** ** | ** **          | ** ** | ** **                                                | ** ** | ** **                                       | ** ** |
| **Balance,  December 31, 2005**    |       | $                                            | 424.2      |                     | $          | (505.9              | )          | $                                                         | (119.7     | )                                                | $          | (393.9 | ) | $ | (595.3 | ) |
| Net income  (loss)                 |       | —                                       |       | (5.1                     | )          | —              |       | —                                                    |       | (5.1                                             | )          |
| Stock plan  activity               |       | (0.2                                         | )          | —                   |       | 15.9                |       | —                                                    |       | 15.7                                             |       |
| Other  comprehensive income (loss) |       | —                                       |       | —                   |       | —              |       | 14.3                                                      |       | 14.3                                             |       |
| **Balance, June 30, 2006**         | ** ** | **$**                                        | **424.0**  | ** **               | **$**      | **(511.0**          | **)**      | **$**                                                     | **(103.8** | **)**                                            | **$**      | **(379.6** | **)** | **$** | **(570.4** | **)** |

 

**W.R. Grace & Co. and SubsidiariesConsolidated Statements of Comprehensive Income (Loss) (Unaudited)***In millions*
| ** **                                | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Net  income (loss)**                    | ** ** | **$**                                           | **(5.2**   | **)**                                         | $          | 32.7 | ** ** | **$** | **(5.1** | **)** | $ | 35.8 |   |
| ** **                                |       |                                            |       |                                          |       |   |   |   |   |
| **Other comprehensive income  (loss):**   |       |                                            |       |                                          |       |   |   |   |   |
| Foreign currency  translation adjustments | ** ** | **13.6**                                        |       | (9.4                                          | )          | **14.6** |   | (22.4 | ) |
| Commodity  hedging activities             | ** ** | **0.3**                                         |       | —                                        | ** ** | **(0.3** | **)** | — |   |
| Total other  comprehensive income (loss)  | ** ** | **13.9**                                        |       | (9.4                                          | )          | **14.3** |   | (22.4 | ) |
| **Comprehensive income (loss)**           | ** ** | **$**                                           | **8.7**    |                                          | $          | 23.3 | ** ** | **$** | **9.2** |   | $ | 13.4 |   |

 

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

 

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

**1.****              Basis ofPresentation and Summary of Significant Accounting and Financial ReportingPolicies**

W. R. Grace &Co., through its subsidiaries, is engaged in specialty chemicals and specialtymaterials businesses on a worldwide basis through two operating segments: “GraceDavison,” which includes silica- and alumina-based catalysts and materials usedin a wide range of industrial applications; and “Grace Performance Chemicals,”which includes specialty chemicals and materials used in commercial andresidential construction and in rigid food and beverage packaging.

W. R. Grace &Co. conducts substantially all of its business through a direct, wholly-ownedsubsidiary,W. R. Grace & Co.-Conn. (“Grace-Conn.”). Grace-Conn. owns substantially allof the assets, properties and rights of W. R. Grace & Co. on a consolidatedbasis, 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 adverse developmentsin its asbestos-related litigation, including: a significant increase inpersonal injury claims, higher than expected costs to resolve personal injuryand certain property damage claims, and class action lawsuits alleging damagesfrom Zonolite Attic Insulation (“ZAI”) a former Grace attic insulation 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”), Graceand 61 of its United States subsidiaries and affiliates, including Grace-Conn.(collectively, the “Debtors”), filed voluntary petitions for reorganization(the “Filing”) under Chapter 11 of the United States Bankruptcy Code in theUnited States Bankruptcy Court for the District of Delaware (the “BankruptcyCourt”). The cases were consolidated and are being jointly administered undercase number 01-01139 (the “Chapter 11 Cases”). Grace’s non-U.S. subsidiariesand certain of its U.S. subsidiaries were not included in the Filing.

Under Chapter 11, theDebtors 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 Chapter11 Related Information.)

***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 six-month interim periods ended June 30,2006 are not necessarily indicative of the results of operations for the yearending December 31, 2006.

***Reclassifications***—****Certain amounts in prior years’ Consolidated FinancialStatements have been reclassified to conform to the 2006 presentation.

***Use of Estimates***—****The preparation of financial statements inconformity with U.S. generally accepted accounting principles requires thatmanagement make estimates and assumptions affecting the assets and liabilitiesreported at the date of the Consolidated Financial Statements, and the revenuesand expenses reported for the periods presented. Actual amounts could differfrom those estimates, and the differences could be material.  Changes in estimates are recorded in theperiod identified. Grace’s accounting measurements that are most affected bymanagement’s estimates of future events are:

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·                  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), income taxes (see Note12), and litigation (see Note 12);

·                  Pensionand postretirement liabilities that depend on assumptions regarding discountrates and total returns on invested funds (see Note 13);

·                  Liabilitiesfor employee incentive compensation and customer rebates that depend on estimatesof 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*******—****InJune 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertaintyin Income Taxes,” an interpretation of FASB Statement No. 109 (“FIN 48”), whichprescribes a recognition threshold and measurement attribute for tax positionstaken 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 is currentlyevaluating the impact to its Consolidated Financial Statements. 

In December 2004,the FASB issued Statement of Financial Accounting Standards (“SFAS”) No.123(R), “Share-Based Payment,” to require companies to measure and recognize inoperations the cost of employee services received in exchange for an award ofequity instruments based on the grant-date fair value. The provisions of thisstandard are effective for Grace in 2006. Grace implemented SFAS 123(R) in thefirst quarter of 2006. Under the transition method selected by Grace, themodified prospective method, the only outstanding awards affected were stockappreciation rights granted to Grace’s former Chief Executive Officer. Gracemeasured the award at a fair value of $2.6 million using the Black-Scholesoption pricing model at March 31, 2006 and recorded that amount as compensationcost (included in selling, general and administrative expenses) in the quarterended March 31, 2006.  Grace recognizedthe $0.6 million decrease in fair value of the stock appreciation rights fromMarch 31, 2006 to June 30, 2006 as a reduction of compensation costs in thequarter ended June 30, 2006. The cumulative effect of this new rule was $1.4million at the beginning of the first quarter of 2006. Grace has not grantedequity options or rights while 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 idle facilityexpense, 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 Related Information**

***Plan of Reorganization***—**On November 13, 2004 Grace filed a plan of reorganization, as well asseveral associated documents, including a disclosure statement, with theBankruptcy Court.  On January 13, 2005,Grace filed an amended plan of reorganization (the “Plan”) and relateddocuments to address certain objections of creditors and other interestedparties. The Plan 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.

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Under the terms of the Plan, a trust would be established under Section524(g) of the Bankruptcy Code to which all pending and future asbestos-relatedclaims would be channeled for resolution. Grace has requested that the Bankruptcy Court conduct an estimationhearing to, among other things, determine the amount that would need to be paidinto the trust on the effective date of the Plan to satisfy the estimatedliability for all classes of asbestos claimants and trust administration costsand expenses over time. The Plan provides that Grace’s asbestos-relatedliabilities would be satisfied using cash and securities from Grace and thirdparties.

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 hasindicated that it will not consider the approval of the disclosure statementuntil after completion of estimation hearings on the amount of Grace’sasbestos-related liability. The Debtors have received extensions of theirexclusive right to propose a plan of reorganization through September 11, 2006.

Under the terms of the Plan, claims would be satisfied under the Chapter11 cases as follows:

Asbestos-Related Claims and Costs

**A trust would be established underSection 524(g) of the Bankruptcy Code to which all pending and futureasbestos-related claims would 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 allasbestos-related personal injury claims against Grace that do not meet thespecific requirements to be PI-SE Claims, but do meet certain other specifiedexposure and medical criteria.

**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 pending property damage claims, excluding ZAIclaims. The case management orders originally contemplated that estimationhearings would take place in September 2006. However, the Bankruptcy Court deferred the estimation process to providethe Debtors and the other stakeholders in the Chapter 11 proceeding with anopportunity to negotiate a resolution of all or a portion of the Debtors’asbestos-related liabilities. **The Bankruptcy Court appointed amediator to facilitate such negotiations that ultimately wereunsuccessful.  As a result, theBankruptcy Court has resumed the estimation process.  Trial dates for estimating liability forpersonal injury claims have been scheduled for June 2007.  Grace expects that hearings for theadjudication of property damage claims will take place during the first quarterof 2007.  The Debtors expect that theestimated liability will provide the basis for determining the Funding Amountto be paid into the trust on the effective date 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, which Gracebelieves would fund over $2 billion in claims, costs and expenses over time.**

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**The PI-SE Claims, the PD Claimsand the related trust administration costs and expenses would be funded with(1) a payment of $512.5 million in cash (plus interest at 5.5% compoundedannually from December 21, 2002) and nine million shares of common stock ofSealed Air Corporation (“Sealed Air”) to be made directly by Cryovac, Inc., awholly owned subsidiary of Sealed Air, (“Cryovac”) to the asbestos trustpursuant to the terms of a settlement agreement resolving asbestos-related,successor liability and fraudulent transfer claims against Sealed Air andCryovac and (2) Grace common stock. The number of shares of Grace common stockrequired to satisfy these claims will depend on the price of Grace common stockon the effective date of the Plan, liability measures approved by theBankruptcy Court, and the value of the Sealed Air settlement, which changesdaily with the accrual of interest and the trading value of Sealed Air commonstock. The Sealed Air settlement agreement has been approved by the BankruptcyCourt, but remains subject to the fulfillment of specified conditions.**

**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 all allowed administrative orpriority claims would be paid 100% in cash and all general unsecured claims,other than those covered by the asbestos trust, would be paid 85% in cash and15% in Grace common stock. Grace estimates that claims with a recorded value ofapproximately $1,212 million, including interest accrued through June 30, 2006,would be satisfied in this manner at the effective date of the Plan. Gracewould finance these payments with cash on hand, cash from Fresenius MedicalCare Holdings, Inc. (“Fresenius”) paid in settlement of asbestos and otherGrace-related claims, new Grace debt, and Grace common stock.  Grace would satisfy other non-asbestosrelated liabilities and claims (primarily certain environmental, tax, pensionand retirement medical obligations) as they become due and payable over timeusing cash flow from operations, insurance proceeds from policies andsettlement agreements covering asbestos-related liabilities, and new creditfacilities. Proceeds from available product liability insurance applicable toasbestos-related claims would supplement operating cash flow to service newdebt and liabilities not paid 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, a person or entity from acquiring more than 4.75% of theoutstanding Grace common stock or, for those persons already holding more than4.75%, prohibit them from increasing or decreasing their holdings. TheBankruptcy Court has also approved the trading restrictions described above,excluding the restriction on sales, until the effective date of the Plan.**

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**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. For example,the asbestos creditors committees and future asbestos claimants representativehave challenged the confirmability of the Plan, arguing that the Plan impairsthe rights of asbestos creditors and impermissibly denies them voting rights,and have asserted that Grace’s asbestos-related liabilities exceed the fairvalue of Grace’s assets.  As a result ofthese challenges and other Bankruptcy Court rulings, a materially differentplan of reorganization may ultimately be approved and, under the ultimate planof reorganization, the interests of the Company’s shareholders could besubstantially diluted or cancelled. The value of Grace common stock following aplan of reorganization, and the extent of any recovery by non-asbestos-relatedcreditors, will depend principally on the allowed value of Grace’sasbestos-related claims as determined by the Bankruptcy Court.**

***Official Parties to Grace’s Chapter 11 Proceedings***— Three creditors’ committees, two representing asbestos claimants andthe third representing other unsecured creditors, and a committee representingshareholders, have been appointed in the Chapter 11 Cases. These committees,and a legal representative of future asbestos claimants, have the right to beheard on all matters that come before the Bankruptcy Court and are likely toplay important roles in the Chapter 11 Cases. The Debtors are required to bearcertain costs and expenses of the committees and of the future asbestosclaimants’ representative, including those of their counsel and financial advisors.

***Claims Filings***— TheBankruptcy Court established a bar date of March 31, 2003 for claims of generalunsecured creditors, asbestos-related property damage claims and medicalmonitoring claims related to asbestos. The bar date did not apply to asbestos-relatedpersonal injury claims or claims related to ZAI, which will be dealt withseparately.

**Approximately 14,900 proofs ofclaim were filed by the bar date. Of these claims, approximately 9,400 werenon-asbestos related, approximately 4,300 were for asbestos-related propertydamage, and approximately 1,000 were for medical monitoring. The medicalmonitoring 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 770 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 June 30,2006, the Debtors had filed objections to approximately 5,400 claims(approximately 100 of which were subsequently withdrawn), approximately 3,950of which were asbestos property damage claims. Of the 5,300 claims,approximately 2,300 have been expunged, approximately 200 have been resolved,approximately 1,900 have been withdrawn by claimants, and the remainingapproximately 900 will be addressed through the claims objection process andthe 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.

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***Litigation Proceedings in Bankruptcy Court*****— In September 2000, Grace was named in apurported class action lawsuit filed in California Superior Court for theCounty of San Francisco, alleging that the 1996 reorganization involving apredecessor of Grace and Fresenius AG and the 1998 reorganization involving apredecessor of Grace and Sealed Air were fraudulent transfers. The BankruptcyCourt authorized the Official Committee of Asbestos Personal Injury Claimantsand the Official Committee of Asbestos Property Damage Claimants to proceedwith claims against Fresenius and Sealed Air and Cryovac on behalf of theDebtors’ bankruptcy estate.

On November 29, 2002,Sealed Air (and Cryovac) and Fresenius each announced that they had reachedagreements in principle with such Committees to settle asbestos, successorliability and fraudulent transfer claims related to such transactions (the “litigationsettlement agreements”). Under the terms of the Fresenius settlement, subjectto the fulfillment of certain conditions, Fresenius would pay $115.0 million tothe Debtors’ estate as directed by the Bankruptcy Court upon confirmation ofthe Debtors’ plan of reorganization. In July 2003, the Fresenius settlement wasapproved by the Bankruptcy Court. Under the terms of the Sealed Air settlement,subject to the fulfillment of certain conditions, Cryovac would make a paymentof $512.5 million (plus interest at 5.5% compounded annually, commencing onDecember 21, 2002) and nine million shares of Sealed Air common stock(collectively valued at $1,087.7 million as of June 30, 2006), as directed bythe Bankruptcy Court upon confirmation of the Debtors’ plan of reorganization.In June 2005, the Sealed Air 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 $250million.  The term of the DIP facilityexpires 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 Entities inReorganization Under the Bankruptcy Code,” promulgated by the AmericanInstitute of Certified Public Accountants. SOP 90-7 requires that financialstatements of debtors-in-possession be prepared on a going concern basis, whichcontemplates continuity of operations, realization of assets and liquidation ofliabilities in the ordinary course of business. However, as a result of the Filing, the realization of certain of theDebtors’ assets and the liquidation of certain of the Debtors’ liabilities aresubject to significant uncertainty. While operating as debtors-in-possession,the Debtors may sell or otherwise dispose of assets and liquidate or settleliabilities for amounts other than those reflected in the ConsolidatedFinancial Statements. Further, the ultimate plan of reorganization couldmaterially change the amounts and classifications reported in the ConsolidatedFinancial Statements.

Pursuant to SOP90-7, Grace’s pre-petition liabilities that are subject to compromise arerequired to be reported separately on the balance sheet at an estimate of theamount that will ultimately be allowed by the Bankruptcy Court. As of June 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 asbestos-related litigation, environmental remediation,and other claims). Obligations of Grace subsidiaries not covered by the Filingcontinue to be classified on the Consolidated Balance Sheets based uponmaturity dates orthe expected dates of payment. SOP 90-7 also requires separate reporting ofcertain expenses, realized gains and losses, and provisions for losses relatedto the Filing as reorganization items.

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 June 30, 2006, was $1,202.7 million comprised of $115.0million in cash from Fresenius and $1,087.7 million in cash and stock fromCryovac. Payments under the Sealed Air settlement will be made directly to theasbestos trust by Cryovac, and will be accounted for as a satisfaction of aportion of Grace’s recorded asbestos-related liability and a credit toshareholder’s equity.

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**Grace’sConsolidated Balance Sheets separately identify the liabilities that are “subjectto compromise” as a result of the Chapter 11 proceedings. In Grace’s case, “liabilitiessubject to compromise” represent pre-petition liabilities as determined underU.S. generally accepted accounting principles. Changes to the recorded amountof such liabilities will be based on developments in the Chapter 11 Cases andmanagement’s assessment of the claim amounts that will ultimately be allowed bythe Bankruptcy Court. Changes to pre-petition liabilities subsequent to theFiling Date reflect: 1) cash payments under approved court orders; 2) the termsof Grace’s proposed plan of reorganization, as discussed above, including theaccrual of interest on pre-petition debt and other fixed obligations; 3)accruals for employee-related programs; and 4) changes in estimates related toother pre-petition contingent liabilities.**

Components ofliabilities subject to compromise are as follows:

 
| ***(In millions)***                     | ** ** | **June 30,  2006** | ** **  | **December 31,  2005** | ** ** |
|----------------------------------------------|------------|-------------------------|-------------|-----------------------------|------------|
| Debt,  pre-petition plus accrued interest    | ** ** | **$**                   | **710.3**   |                        | $          | 684.7 |   |
| Asbestos-related  liability                  | ** ** | **1,700.0**             |        | 1,700.0                     |       |
| Income taxes                                 | ** ** | **134.4**               |        | 136.5                       |       |
| Environmental  remediation                   | ** ** | **368.6**               |        | 342.0                       |       |
| Postretirement  benefits other than pension  | ** ** | **92.0**                |        | 101.3                       |       |
| Unfunded special  pension arrangements       | ** ** | **88.2**                |        | 86.4                        |       |
| Retained  obligations of divested businesses | ** ** | **16.9**                |        | 18.1                        |       |
| Accounts payable                             | ** ** | **31.6**                |        | 31.5                        |       |
| Other accrued  liabilities                   | ** ** | **63.6**                |        | 54.6                        |       |
| **Total Liabilities Subject to  Compromise** | ** ** | **$**                   | **3,205.6** |                        | $          | 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***

The followingchart is a reconciliation of the changes in pre-filing date liability balancesfor the period from the Filing Date through June 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 |       | (312.0                        | )          |
| Expense/(income) items:                                                                             | ** ** | ** **                    | ** ** |
| Interest on pre-petition liabilities                                                                |       | 238.3                         |       |
| Employee-related accruals                                                                           |       | 35.9                          |       |
| 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                                                                              |       | $                             | 3,205.6    |   |

 

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. Beginning January 1, 2006, Gracehas agreed to pay interest on pre-petition bank debt at the prime rate quotedby Bloomberg, adjusted for periodic changes, and compounded quarterly. Theeffective rates for the three months and six months ended June 30, 2006 were7.90% and 7.66%, respectively.  From theFiling Date through December 31, 2005, interest expense on pre-petition bankdebt was accrued at a fixed annual rate of 6.09%, compounded quarterly.

***Chapter 11 Expenses***

 
| ***(In millions)***           | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months  Ended  June 30,** | ** ** |
|------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                         | ** ** | **2006**                                        | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Legal and  financial advisory fees | ** ** | **$**                                           | **13.3**   |                                                | $          | 6.2 | ** ** | **$** | **24.1** |   | $ | 14.0 |   |
| Interest income                    | ** ** | **(1.8**                                        | **)**      | (1.6                                                | )          | **(3.9** | **)** | (3.4 | ) |
| Chapter 11 expenses,  net          | ** ** | **$**                                           | **11.5**   |                                                | $          | 4.6 | ** ** | **$** | **20.2** |   | $ | 10.6 |   |

 

Pursuant to SOP90-7, interest income earned on the Debtors’ cash balances must be offsetagainst Chapter 11 expenses.

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

**W. R. Grace &Co. — Chapter 11 Filing Entities Debtor-in-Possession Statements of Operations***(In millions)*
| ** **                                                                                                                                | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                                                                | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
| Net sales,  including intercompany                                                                                                        | ** ** | **$**                                         | **733.8**  |   | $ | 638.3 |   |
| Cost of goods  sold, including intercompany, exclusive of depreciation and amortization  shown separately below                           | ** ** | **549.4**                                     |       | 439.3 |   |
| Selling, general  and administrative expenses, exclusive of net pension expense and  depreciation and amortization shown separately below | ** ** | **170.6**                                     |       | 134.5 |   |
| Research and  development expenses                                                                                                        | ** ** | **20.4**                                      |       | 19.2 |   |
| Depreciation and  amortization                                                                                                            | ** ** | **29.3**                                      |       | 32.5 |   |
| Net pension  expense                                                                                                                      | ** ** | **23.2**                                      |       | 26.7 |   |
| Interest expense  and related financing costs                                                                                             | ** ** | **35.6**                                      |       | 27.5 |   |
| Provision for  environmental remediation                                                                                                  | ** ** | **30.0**                                      |       | — |   |
| Other (income)  expense                                                                                                                   | ** ** | **(28.5**                                     | **)**      | (48.6 | ) |
|                                                                                                                                      | ** ** | **830.0**                                     |       | 631.1 |   |
| Income (loss)  before Chapter 11 expenses, income taxes, and equity in net income of  non-filing entities                                 | ** ** | **(96.2**                                     | **)**      | 7.2 |   |
| Chapter 11  expenses, net                                                                                                                 | ** ** | **(20.2**                                     | **)**      | (10.4 | ) |
| Benefit from  (provision for) income taxes                                                                                                | ** ** | **23.2**                                      |       | (8.7 | ) |
| Income (loss)  before equity in net income of non-filing entities                                                                         | ** ** | **(93.2**                                     | **)**      | (11.9 | ) |
| Equity in net  income of non-filing entities                                                                                              | ** ** | **88.1**                                      |       | 47.7 |   |
| **N****et income (loss)**                                                                                                                 | ** ** | **$**                                         | **(5.1**   | **)** | $ | 35.8 |   |

 

 

I-14

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**W. R. Grace &Co. — Chapter 11 Filing Entities Debtor-in-Possession Condensed Statements of CashFlows***(**In millions)*

 
| ** **                                                                                     | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                     | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
| **Operating Activities**                                                                       | ** ** | ** **                                    | ** ** | ** ** | ** ** |
| Net income  (loss)                                                                             | ** ** | **$**                                         | **(5.1**   | **)** | $ | 35.8 |   |
| Reconciliation to net  cash provided by (used for) operating activities:                       |       |                                          |       |   |   |
| Chapter 11 expenses, net                                                                       | ** ** | **20.2**                                      |       | 10.4 |   |
| (Benefit from) provision for income taxes                                                      | ** ** | **(23.2**                                     | **)**      | 8.7 |   |
| Equity in net income of non-filing entities                                                    | ** ** | **(88.1**                                     | **)**      | (47.7 | ) |
| Depreciation and amortization                                                                  | ** ** | **29.3**                                      |       | 32.5 |   |
| Interest on pre-petition liabilities subject to  compromise                                    | ** ** | **34.7**                                      |       | 25.4 |   |
| Provision for environmental remediation                                                        | ** ** | **30.0**                                      |       | — |   |
| Other non-cash items, net                                                                      | ** ** | **1.1**                                       |       | (1.9 | ) |
| Contributions to defined benefit pension plans                                                 | ** ** | **(32.8**                                     | **)**      | (8.3 | ) |
| Cash paid to settle noncore contingencies                                                      | ** ** | **—**                                    |       | (119.7 | ) |
| Changes in other assets and liabilities, excluding  the effect of businesses acquired/divested | ** ** | **(54.4**                                     | **)**      | (79.5 | ) |
| **Net  cash provided by (used for) operating activities**                                      | ** ** | **(88.3**                                     | **)**      | (144.3 | ) |
| **Investing Activities**                                                                       |       |                                          |       |   |   |
| Capital expenditures                                                                           | ** ** | **(40.1**                                     | **)**      | (23.7 | ) |
| Loan repayments  and other                                                                     | ** ** | **46.6**                                      |       | 64.9 |   |
| **Net  cash provided by (used for) investing activities**                                      | ** ** | **6.5**                                       |       | 41.2 |   |
| **Net  cash provided by (used for) financing activities**                                      | ** ** | **(1.1**                                      | **)**      | (1.7 | ) |
| **Net  increase (decrease) in cash and cash equivalents**                                      | ** ** | **(82.9**                                     | **)**      | (104.8 | ) |
| Cash and cash  equivalents, beginning of period                                                | ** ** | **269.2**                                     |       | 340.0 |   |
| Cash and cash  equivalents, end of period                                                      | ** ** | **$**                                         | **186.3**  |   | $ | 235.2 |   |

 

I-15

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**W. R. Grace &Co. —Chapter 11 Filing Entities Debtor-in-Possession Balance Sheets***(**In millions)*
| ** **                                                     | ** ** | **June 30,  2006** | ** **  | **December 31,  2005** | ** ** |
|----------------------------------------------------------------|------------|-------------------------|-------------|-----------------------------|------------|
| **ASSETS**                                                     | ** ** | ** **              | ** **  | ** **                  | ** ** |
| **Current Assets**                                             | ** ** | ** **              | ** **  | ** **                  | ** ** |
| Cash and cash  equivalents                                     | ** ** | **$**                   | **186.3**   |                        | $          | 269.2 |   |
| Trade accounts  receivable, net                                | ** ** | **142.4**               |        | 108.0                       |       |
| Receivables from  non-filing entities, net                     | ** ** | **68.1**                |        | 62.3                        |       |
| Inventories                                                    | ** ** | **85.9**                |        | 86.8                        |       |
| Other current  assets                                          | ** ** | **39.9**                |        | 53.5                        |       |
| **Total  Current Assets**                                      | ** ** | **522.6**               |        | 579.8                       |       |
| Properties and  equipment, net                                 | ** ** | **384.3**               |        | 378.9                       |       |
| Cash value of  life insurance policies, net of policy loans    | ** ** | **86.6**                |        | 84.8                        |       |
| Deferred income  taxes                                         | ** ** | **723.4**               |        | 701.0                       |       |
| Asbestos-related  insurance                                    | ** ** | **500.0**               |        | 500.0                       |       |
| Loans receivable  from non-filing entities, net                | ** ** | **279.3**               |        | 306.9                       |       |
| Investment in  non-filing entities                             | ** ** | **642.4**               |        | 527.9                       |       |
| Other assets                                                   | ** ** | **82.8**                |        | 79.3                        |       |
| **Total  Assets**                                              | ** ** | **$**                   | **3,221.4** |                        | $          | 3,158.6 |   |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY (DEFICIT)**       | ** ** | ** **              | ** **  | ** **                  | ** ** |
| **Liabilities Not Subject to  Compromise**                     | ** ** | ** **              | ** **  | ** **                  | ** ** |
| Current  liabilities                                           | ** ** | **$**                   | **171.9**   |                        | $          | 187.3 |   |
| Minority  interest in consolidated affiliates                  | ** ** | **49.9**                |        | 32.6                        |       |
| Other  liabilities                                             | ** ** | **364.4**               |        | 378.9                       |       |
| **Total  Liabilities Not Subject to Compromise**               | ** ** | **586.2**               |        | 598.8                       |       |
| **Liabilities  Subject to Compromise**                         | ** ** | **3,205.6**             |        | 3,155.1                     |       |
| **Total  Liabilities**                                         | ** ** | **3,791.8**             |        | 3,753.9                     |       |
| **Shareholders’  Equity (Deficit)**                       | ** ** | **(570.4**              | **)**       | (595.3                      | )          |
| **Total Liabilities and  Shareholders’ Equity (Deficit)** | ** ** | **$**                   | **3,221.4** |                        | $          | 3,158.6 |   |

 

In addition toGrace’s financial reporting obligations as prescribed by the U.S. Securitiesand Exchange 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.

**3.****              Asbestos-RelatedLitigation**

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 forproperty damage (one of which has since been dismissed), and the remainderinvolving 129,191 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***—******The plaintiffsin asbestos property damage lawsuits generally seek to have the defendants payfor the cost of removing, containing or repairing the asbestos-containingmaterials in the affected buildings. Each property damage case is unique inthat the age, type, size and use of the building, and the difficulty ofasbestos abatement, if necessary, vary from structure to structure. Informationregarding product identification, the amount of product in the building, theage, type, size and use of the building, the legal status of the claimant, thejurisdictional history of prior cases and the court in which the case ispending has provided meaningful guidance as to the range of potential costs.

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 were entered in favor of Grace in nine cases(excluding cases settled following appeals of judgments in favor of Grace);judgments were entered in favor of the plaintiffs in eight cases (one of whichis on appeal) for a total of $86.1 million; 207 property damage cases weresettled for a total of $696.8 million; and 16 cases remain outstanding(including the one on appeal). Of the 16 remaining cases, eight relate to ZAIand eight relate to a number of former asbestos-containing products (two ofwhich also are alleged to involve ZAI).

I-16

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Approximately4,300 additional property damage claims were filed prior to the March 31, 2003claims bar date established by the Bankruptcy Court. (The bar date did notapply to ZAI claims.) Such claims were reviewed in detail by Grace, categorizedinto claims 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 July 31, 2006,following the reclassification, withdrawal or expungement of claims,approximately 850 property damage claims remain outstanding.

Eight of the ZAIcases were filed as purported class action lawsuits in 2000 and 2001. Inaddition, eight lawsuits were filed as purported class actions in 2004 and 2005with respect to persons and homes in Canada. These cases seek damages andequitable relief, including the removal, replacement and/or disposal of allsuch insulation. The plaintiffs assert that this product is in millions ofhomes and that the cost of removal could be several thousand dollars per home.As a result of the Filing, the eight U.S. cases have been transferred to theBankruptcy Court.  Based on Grace’sinvestigation of the claims described in these lawsuits, and testing and analysisof this product by Grace and others, Grace believes that the product was andcontinues to be safe for its intended purpose and poses little or no threat tohuman health. The plaintiffs in the ZAI lawsuits (and the U.S. government inthe Montana criminal proceeding described in Note 12) dispute Grace’s positionon the safety of ZAI. In July 2002, the Bankruptcy Court approved specialcounsel to represent, at the Debtors’ expense, the ZAI claimants in aproceeding to determine certain threshold scientific issues regarding ZAI. OnOctober 18, 2004, the Bankruptcy Court held a hearing on motions filed by theparties to address a number of important legal and factual issues regarding theZAI claims, and has taken the motions under advisement. No decision has yetbeen rendered.  Grace’s recordedasbestos-related liability at June 30, 2006 assumes the risk of loss from ZAIlitigation is not probable.  If Grace’sview as to risk of loss were not sustained, management believes the cost toresolve the matter would be material.

***Personal Injury Litigation***—****Asbestos personal injury claimants allege adverse healtheffects from exposure to asbestos-containing products formerly manufactured byGrace. Claims are generally similar to each other, differing primarily in thetype of asbestos-related illness allegedly suffered by the plaintiff. Grace’scost to resolve such claims has been influenced by numerous variables,including the solvency of other former producers of asbestos containingproducts, cross-claims by co-defendants, the rate at which new claims arefiled, the jurisdiction in which the claims are filed, and the defense anddisposition costs associated with these claims.

Cumulativelythrough the Filing Date, 16,354 asbestos personal injury lawsuits involvingapproximately 35,720 claims were dismissed without payment of any damages orsettlement amounts (primarily on the basis that Grace products were notinvolved) and approximately 55,489 lawsuits involving approximately 163,698claims were disposed of (through settlements and judgments) for a total of$645.6 million.  As of the Filing Date,129,191 claims for personal injury were pending against Grace. Grace believesthat a substantial number of additional personal injury claims would have beenreceived between the Filing Date and June 30, 2006 had such claims not beenstayed by the Bankruptcy Court.

***Asbestos-Related Liability***—****The total recordedasbestos-related liability balance as of June 30, 2006 and December 31, 2005was $1,700.0 million and is included in “liabilities subject to compromise” inthe accompanying Consolidated Balance Sheets. Grace adjusted its asbestos-related liability in the fourth quarter of2004 based on its proposed plan of reorganization as discussed in Note 2. Theamount recorded at June 30, 2006 includes the $1,613 million maximum amountreflected as a condition precedent to the Plan and $87 million related topre-Chapter 11 contractual settlements and judgments included in generalunsecured 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 tofund over $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.

I-17

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The BankruptcyCourt has entered separate case management orders for estimating liability forpending and future personal injury claims and pending property damage claims,excluding ZAI claims. The case management orders originally contemplated thatestimation hearings would take place in September 2006.  However, the Bankruptcy Court deferred theestimation process to provide the Debtors and the other stakeholders in theChapter 11 proceeding with an opportunity to negotiate a resolution of all or aportion of the Debtors’ asbestos-related liabilities.  The Bankruptcy Court appointed a mediator tofacilitate such negotiations that ultimately were unsuccessful.  As a result, the Bankruptcy Court has resumedthe estimation process.  The Debtorsexpect that the estimated liability will provide the basis for determining theFunding Amount to be paid into 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 must complete detailed questionnaires providinginformation on, among other things, their medical condition, includingdiagnostic support, exposure to Grace and non-Grace asbestos-containingproducts, employment history, and pending lawsuits against other companies.

Approximately60,000 questionnaires were returned in response to the July 12, 2006 deadline.  From a preliminary examination, Gracebelieves that a substantial percentage of the submitted questionnaires provideinsufficient or incomplete responses, and has requested that the BankruptcyCourt issue an order to compel the asbestos personal injury claimants to curethese deficiencies.  The Bankruptcy Courtalso has indicated that it will set a bar date for asbestos personal injuryclaims pending as of the Filing Date (other than settled but unpaid claims).

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 conclude in a three-week trial scheduledfor June 2007.

For propertydamage claims, the case management order provides that estimation will bepreceded by litigation on certain common threshold issues affecting asubstantial majority of claims. Such litigation will consist of determining,among other things, (1) whether asbestos-containing products formerlymanufactured by Grace are hazardous in place, (2) the date by****which building owners knew or should haveknown of the reported hazards of asbestos-containing materials****in their buildings, which would providethe basis for a statute of limitations defense, and (3) the evidentiaryadmissibility of certain asbestos testing methodologies. During the periodpreceding the estimation hearing, Grace will also ask****the Bankruptcy Court to rule on Grace’s specific objectionsto individual claims and groups of claims. Claims not resolved or expungedthrough the common issue litigation or the objection process would be thesubject of an estimation hearing that Grace expects will take place during thefirst quarter of 2007.

The Funding Amountwill be primarily a function of the number of estimated allowed property damageand personal injury claims, and the amount payable per claim. Through the estimationprocess, Grace will seek to demonstrate that most claims should not be allowedbecause 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.

I-18

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Conversely, theasbestos claimants committees and the future claimants representative continueto assert that Grace’s asbestos-related liabilities are substantially higherthan $1,613 million, and in fact are in excess of Grace’s business value.  If the Court accepts the position of theasbestos claimants committees, then any plan of reorganization likely wouldresult in the loss of all or substantially all equity value by currentshareholders. Therefore, due to the significant uncertainties of this processand asbestos litigation generally, Grace is not able to estimate a probableFunding 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 Cryovac directlyto the asbestos trust under the settlement agreement described in Note 2),during the fourth quarter of 2004, Grace accrued a charge of $714.8 million toincrease its recorded asbestos-related liability to reflect the maximum amountallowed 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 June 30, 2006 and December 31,2005 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 June 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 more than54 presently solvent insurers.

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-relatedliability of $1,700 million. Grace believes that any allowed ZAI claims alsowould be covered under the settlement agreements and unsettled policiesdiscussed above to the extent they relate to installations of ZAI occurringafter 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. Acquisitionsand 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.

I-19

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During the first sixmonths of 2005, Grace completed two acquisitions for a total cash cost of $2.5million 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  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                       | ** ** | **2006**                                        | ** ** | **2005**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
| Income from  insurance settlements                               | ** ** | **$**                                           | **(6.9**   | **)**                                    | $          | (20.3 | ) | **$** | **(6.9** | **)** | $ | (20.3 | ) |
| COLI income, net                                                 | ** ** | **(0.5**                                        | **)**      | (0.6                                     | )          | **(1.7** | **)** | (1.9 | ) |
| Interest income                                                  | ** ** | **(1.6**                                        | **)**      | (0.9                                     | )          | **(3.0** | **)** | (1.6 | ) |
| Net (gain) loss  on sales of investments and disposals of assets | ** ** | **(4.6**                                        | **)**      | 0.4                                      | ** ** | **(2.8** | **)** | (0.5 | ) |
| Currency  translation — intercompany loan                   | ** ** | **(10.7**                                       | **)**      | 16.5                                     | ** ** | **(13.7** | **)** | 31.4 |   |
| Value of  currency contracts                                     | ** ** | **10.7**                                        |       | (16.7                                    | )          | **13.5** |   | (31.2 | ) |
| Other currency  transaction effects                              | ** ** | **1.7**                                         |       | 0.3                                      | ** ** | **2.7** |   | 0.5 |   |
| Other  miscellaneous income                                      | ** ** | **(2.0**                                        | **)**      | (2.6                                     | )          | **(3.9** | **)** | (6.4 | ) |
| Total other (income)  expense                                    | ** ** | **$**                                           | **(13.9**  | **)**                                    | $          | (23.9 | ) | **$** | **(15.8** | **)** | $ | (30.0 | ) |

 

**6. Other BalanceSheet Accounts**

 
| ***(In millions)***                                                     | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **Inventories**                                                              | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Raw materials                                                                | ** ** | **$**                   | **73.2**   |                        | $          | 67.3 |   |
| In process                                                                   | ** ** | **37.8**                |       | 32.8                        |       |
| Finished  products                                                           | ** ** | **207.4**               |       | 210.8                       |       |
| General  merchandise                                                         | ** ** | **32.5**                |       | 33.2                        |       |
| Less: Adjustment  of certain inventories to a last-in/first-out (LIFO) basis | ** ** | **(41.6**               | **)**      | (65.8                       | )          |
|                                                                         | ** ** | **$**                   | **309.3**  |                        | $          | 278.3 |   |
| **Other Assets**                                                             |       |                    |       |                        |       |
| Deferred pension  costs                                                      | ** ** | **$**                   | **115.0**  |                        | $          | 108.8 |   |
| Deferred charges                                                             | ** ** | **11.8**                |       | 20.8                        |       |
| Long-term  receivables, less allowances of $0.8 (2005 - $0.7)                | ** ** | **7.5**                 |       | 7.6                         |       |
| Patents,  licenses and other intangible assets, net                          | ** ** | **101.6**               |       | 87.6                        |       |
| Pension-unamortized  prior service cost                                      | ** ** | **12.7**                |       | 12.7                        |       |
| Investments in  unconsolidated affiliates and other                          | ** ** | **0.5**                 |       | 0.6                         |       |
|                                                                         | ** ** | **$**                   | **249.1**  |                        | $          | 238.1 |   |
| **Other Current Liabilities**                                                | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Accrued  compensation                                                        | ** ** | **$**                   | **65.6**   |                        | $          | 70.4 |   |
| Deferred tax  liability                                                      | ** ** | **0.9**                 |       | 0.8                         |       |
| Customer volume  rebates                                                     | ** ** | **29.4**                |       | 35.4                        |       |
| Accrued  commissions                                                         | ** ** | **10.5**                |       | 11.1                        |       |
| Accrued  reorganization fees                                                 | ** ** | **21.4**                |       | 18.0                        |       |
| Other accrued  liabilities                                                   | ** ** | **63.7**                |       | 62.2                        |       |
|                                                                         | ** ** | **$**                   | **191.5**  |                        | $          | 197.9 |   |

 

Accrued compensation in the table above includescurrent amounts due through June 30, 2007 under the annual and long-termincentive programs. Other liabilities in the Consolidated Balance Sheetincludes amounts expected to be paid under these programs after July 1, 2007.

**7.****              Life Insurance**

Graceis the beneficiary of corporate-owned life insurance (“COLI”) policies on certaincurrent and former employees with a net cash surrender value of $86.6 millionand $84.8 million at June 30, 2006 and December 31, 2005, respectively. Thepolicies were acquired to fund various employee benefit programs and otherlong-term liabilities and are structured to provide cash flow (primarilytax-free) over an extended number of years.

I-20

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The followingtables summarize activity in these policies for the six months ended June 30,2006 and 2005, and the components of net cash value at June 30, 2006 andDecember 31, 2005:
| **Life Insurance — Activity Summary***(In millions) * | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                               | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
| Earnings on  policy assets                                                               | ** ** | **$**                                         | **2.4**    |   | $ | 4.1 |   |
| Interest on  policy loans                                                                | ** ** | **(0.7**                                      | **)**      | (2.2 | ) |
| Policy loan  repayments                                                                  | ** ** | **—**                                    |       | 0.6 |   |
| Proceeds from  termination of life insurance policies                                    | ** ** | **—**                                    |       | (14.8 | ) |
| Net investing  activity                                                                  | ** ** | **0.1**                                       |       | (2.4 | ) |
| Change in net  cash value                                                                | ** ** | **$**                                         | **1.8**    |   | $ | (14.7 | ) |
| Tax-free proceeds  received                                                              | ** ** | **$**                                         | **0.2**    |   | $ | 2.4 |   |

 
| **Components of Net Cash Value***(In  millions)* | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Gross cash value                                 | ** ** | **$**                   | **111.5**  |                        | $          | 109.2 |   |
| Principal —  policy loans                   | ** ** | **(23.7**               | **)**      | (23.7                       | )          |
| Accrued interest  — policy loans            | ** ** | **(1.2**                | **)**      | (0.7                        | )          |
| Net cash value                                   | ** ** | **$**                   | **86.6**   |                        | $          | 84.8 |   |
| Insurance benefits in  force                     | ** ** | **$**                   | **197.2**  |                        | $          | 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)*      | ** ** | **June 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                                          | ** ** | **14.0**                |       | 14.3                        |       |
| Accrued interest                                          | ** ** | **196.3**               |       | 170.4                       |       |
|                                                      | ** ** | **$**                   | **710.3**  |                        | $          | 684.7 |   |
| Annualized weighted  average interest rates on total debt | ** ** | **7.6**                 | **%**      | 6.1                         | %          |

 

In April 2001, theDebtors entered into the DIP facility for a two-year term in the aggregateamount of $250 million. The DIP facility is secured by a priority lien onsubstantially all assets of the Debtors with the exclusion of foreign stockholdings, and bears interest based on the London Interbank Offered Rate(LIBOR). The Debtors have extended the term of the DIP facility through April1, 2008. Grace had no outstanding borrowings under the DIP facility as of June30, 2006; however, $42.1 million of standby letters of credit were issued andoutstanding under the facility. The letters of credit, which reduce availablefunds under the facility, were issued primarily for trade-related matters suchas performance bonds, and certain insurance and environmental matters.

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

Under its Certificate ofIncorporation, the Company is authorized to issue 300,000,000 shares of commonstock, $0.01 par value. Of the common stock unissued at June 30, 2006,approximately 5,253,838 shares were reserved for issuance pursuant to stockoptions and other stock incentives. Since the Filing Date, Grace has notgranted any stock options.

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

**10.****             Earnings (Loss) PerShare**

The followingtable shows a reconciliation of the numerators and denominators used incalculating basic and diluted earnings (loss) per share.
| **Earnings (Loss) Per Share***(In millions, except per share amounts)* | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                                     | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Numerators**                                                                                                 | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss)                                                                                              | ** ** | **$**                                           | **(5.2**   | **)**                                         | $          | 32.7 | ** ** | **$** | **(5.1** | **)** | $ | 35.8 |   |
| **Denominators**                                                                                               |       |                                            |       |                                          |       |   |   |   |   |
| Weighted average common shares— basic calculation                                                         | ** ** | **67.9**                                        |       | 66.9                                          | ** ** | **67.5** |   | 66.8 |   |
| Dilutive effect of employee stock options                                                                      | ** ** | **—**                                      |       | 0.3                                           | ** ** | **—** |   | 0.5 |   |
| Weighted average common shares—diluted calculation                                                        | ** ** | **67.9**                                        |       | 67.2                                          | ** ** | **67.5** |   | 67.3 |   |
| **Basic  earnings (loss) per share**                                                                           | ** ** | **$**                                           | **(0.08**  | **)**                                         | $          | 0.49 | ** ** | **$** | **(0.08** | **)** | $ | 0.54 |   |
| **Diluted earnings (loss) per  share**                                                                         | ** ** | **$**                                           | **(0.08**  | **)**                                         | $          | 0.49 | ** ** | **$** | **(0.08** | **)** | $ | 0.53 |   |

 

As a result of the net losses recorded for the threemonths and six months ended June 30, 2006, approximately 500,000 and 400,000,respectively, of employee compensation-related shares issuable under stockoptions were excluded from the diluted loss per share calculation because theireffect would have been antidilutive.

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**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 six months ended June 30,2006 and 2005:
| **Three Months Ended June 30, 2006***(In millions)* | ** ** | **Pre-Tax  Amount** | ** ** | **Tax  Expense** | ** ** | **After-  Tax  Amount** | ** ** |
|-----------------------------------------------------------------------------------|------------|---------------------|------------|------------------|------------|-------------------------|------------|
| Commodity  hedging activities                                                     |       | $                   | 0.5        |             | $          | (0.2                    | )          | **$** | **0.3** | ** ** |
| Foreign currency  translation adjustments                                         |       | 13.6                |       | —           | ** ** | **13.6**                | ** ** |
| Other  comprehensive income (loss)                                                |       | $                   | 14.1       |             | $          | (0.2                    | )          | **$** | **13.9** | ** ** |

 
| **Six Months Ended June 30, 2006**(*In millions)* | ** ** | **Pre-Tax  Amount** | ** ** | **Tax  Benefit** | ** ** | **After-  Tax  Amount** | ** ** |
|---------------------------------------------------------------------------------|------------|---------------------|------------|------------------|------------|-------------------------|------------|
| Commodity  hedging activities                                                   |       | $                   | (0.4       | )                | $          | 0.1                     | ** ** | **$** | **(0.3** | **)** |
| Foreign currency  translation adjustments                                       |       | 14.6                |       | —           | ** ** | **14.6**                | ** ** |
| Other comprehensive  income (loss)                                              |       | $                   | 14.2       |             | $          | 0.1                     | ** ** | **$** | **14.3** | ** ** |

 
| **Three Months Ended June 30, 2005***(In millions)* | ** ** | **Pre-Tax  Amount** | ** ** | **Tax  Benefit** | ** ** | **After-  Tax  Amount** | ** ** |
|-----------------------------------------------------------------------------------|------------|---------------------|------------|------------------|------------|-------------------------|------------|
| Foreign currency  translation adjustments                                         |       | $                   | (9.4       | )                | $          | —                  |       | $ | (9.4 | ) |
| Other comprehensive  income (loss)                                                |       | $                   | (9.4       | )                | $          | —                  |       | $ | (9.4 | ) |

 
| **Six Months Ended June 30, 2005***(In millions)* | ** ** | **Pre-Tax  Amount** | ** ** | **Tax  Benefit** | ** ** | **After-  Tax  Amount** | ** ** |
|---------------------------------------------------------------------------------|------------|---------------------|------------|------------------|------------|-------------------------|------------|
| Foreign currency  translation adjustments                                       |       | $                   | (22.4      | )                | $          | —                  |       | $ | (22.4 | ) |
| Other comprehensive  income (loss)                                              |       | $                   | (22.4      | )                | $          | —                  |       | $ | (22.4 | ) |

 

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 six months of 2006, Grace purchased forward contracts, swaps andoptions for a portion of its expected natural gas requirements. The outstandingswaps and options were treated as effective cash flow hedges for accountingpurposes and revalued at the end of each of the first two quarters of 2006,with corresponding adjustments to other comprehensive income (loss).

The followingtable presents the components of Grace’s accumulated other comprehensive income(loss) at June 30, 2006 and December 31, 2005:
| **Components of Accumulated Other Comprehensive Income (Loss)***(In millions)* | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Commodity  hedging (net of tax)                                                                                   | ** ** | **$**                   | **(0.3**   | **)**                       | $          | — |   |
| Minimum pension  liability (net of tax)                                                                           | ** ** | **(362.7**              | **)**      | (362.7                      | )          |
| Foreign currency  translation                                                                                     | ** ** | **(16.6**               | **)**      | (31.2                       | )          |
| Accumulated other  comprehensive income (loss)                                                                    | ** ** | **$**                   | **(379.6** | **)**                       | $          | (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.****             Commitments andContingent Liabilities**

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

***Environmental Remediation***—****Grace is subject to loss contingencies resulting fromextensive and evolving federal, state, local and foreign environmental laws andregulations relating to the generation, storage, handling, discharge anddisposition of hazardous wastes and other materials. Grace accrues foranticipated costs associated with investigative and remediation efforts wherean assessment has indicated that a probable liability has been incurred and thecost can be reasonably estimated. These accruals do not take into account anydiscounting for the time value of money.

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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 June 30, 2006,Grace’s estimated liability for environmental investigative and remediationcosts totaled $368.6 million, as compared with $342.0 million at December 31,2005. The amount is based on funding and/or remediation agreements in place andGrace’s best estimate of its cost for sites not subject to a formal remediationplan. Grace’s estimated environmental liabilities are included in “liabilitiessubject to compromise” in the accompanying Consolidated 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 six monthsended June 30, 2006 and 2005 were $3.4 million and $24.4 million,respectively.  The decrease in theliability in 2005 was primarily due to a settlement payment of $21.4 millionrelated to a formerly owned site, which was approved by the Bankruptcy Court.

*VermiculiteRelated Matters*

EPA Lawsuit— In November 1999, Region 8 of the Environmental Protection Agency (“EPA”)began an investigation into alleged excessive levels of asbestos-relateddisease in the Libby population related to Grace’s former mining activities inLibby, Montana. This investigation led the EPA to undertake additionalinvestigative activity and to carry out response actions in and around Libby.On March 30, 2001, the EPA filed a lawsuit in U.S. District Court for theDistrict of Montana, Missoula Division (*United States v. W. R.Grace & Company et al.*) under the Comprehensive EnvironmentalResponse, Compensation and Liability Act for the recovery of costs allegedlyincurred by the United States in response to the release or threatened releaseof asbestos in the Libby, Montana area relating to such former miningactivities. These costs include cleaning and/or demolition of contaminatedbuildings, excavation and removal of contaminated soil, health screening ofLibby residents and former mine workers, and investigation and monitoringcosts. In this action, the EPA also sought a declaration of Grace’s liabilitythat would be binding in future actions to recover 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 ofdocumentation of the EPA’s cost recovery claims through December 31, 2001. OnAugust 28, 2003, the District Court issued a ruling in favor of the UnitedStates that requires Grace to reimburse the government for $54.5 million (plusinterest) in costs expended through December 2001, and for all appropriatefuture costs to complete the remediation activities. The Ninth Circuit Court ofAppeals upheld the District Court’s rulings. Grace has appealed this case to the U.S. Supreme Court.

Grace’s totalestimated liability for vermiculite-related remediation, including the $54.5million mentioned above and the cost of remediation of vermiculite processingsites outside of Libby, at June 30, 2006 and December 31, 2005 was $255.4million and $226.2 million, respectively. The estimate at June 30, 2006 includes $118.0 million for assertedreimbursable costs covering 2002 through 2005 based on recent informationreceived from the U.S. Government, an increase of $28.0 million over Grace’sestimate for the same period at December 31, 2005.  The current estimate does not include thecost to remediate the Grace-owned mine site at Libby, which is not currentlyestimable. Grace’s estimate of costs is based on U.S. Government spending datathrough December 31, 2005, public comments regarding the EPA’s spending plans,discussions of spending forecasts with EPA representatives, analysis of otherinformation made available from the EPA, and evaluation of probable remediationcosts at vermiculite processing sites. However, the EPA’s cost estimates haveincreased regularly and substantially over the course of this remediation.Consequently, as the EPA’s spending on these matters increases, Grace’sliability for remediation will increase.

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MontanaCriminal Proceeding****—****On February 7, 2005, the United States Department ofJustice announced the unsealing of a grand jury indictment against Grace andseven current or former senior level employees *(UnitedStates of America v. W. R. Grace & Co. et al)* relating to Grace’sformer vermiculite 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) obstruction ofjustice. The U.S. District Court for the District of Montana has entered ascheduling order setting a trial date of September 11, 2006.  In July 2006, the Court dismissed a portionof the conspiracy count of a superseding indictment alleging conspiracy toknowingly endanger residents of the Libby area and others in violation of theClean Air Act.

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.

The U.S. Bankruptcy Courtpreviously granted Grace’s request to advance legal and defense costs to theemployees, subject to a reimbursement obligation if it is later determined thatthe employees did not meet the standards for indemnification set forth underthe appropriate state corporate law. For the six months ended June 30, 2006 and2005, total expense for Grace and the employees was $27.2 million and $8.7million respectively, which amounts are included in selling, general andadministrative expenses in the accompanying Consolidated Statements ofOperations.

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. However, Grace expects legal fees for this matter couldrange from $10 million to $20 million per quarter through the trial.  Grace intends to expense such costs as theyare incurred.

New Jersey Lawsuit— On June 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 of NewJersey 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 June 30, 2006and December 31, 2005, Grace’s estimated liability for remediation of sites notrelated to its former vermiculite mining and processing activities was $113.2million and $115.8 million, respectively. This liability relates to Grace’scurrent and former operations, including its share of liability for off-sitedisposal at facilities where it has been identified as a potentiallyresponsible party.  Grace’s estimatedliability is based upon an evaluation of claims for which sufficientinformation was available. As Grace receives new information and continues itsclaims evaluation process, its estimated liability may change materially.

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***Tax Matters*** - On May 19, 2005, Gracereceived a revised examination report (the “1993-1996 Examination Report”) fromthe Internal Revenue Service (the “IRS”) for the 1993-1996 tax periodsasserting, in the aggregate, approximately $77.3 million of proposed taxadjustments, plus****accruedinterest. The most significant issue addressed in the 1993-1996 ExaminationReport concerns interest deductions claimed with respect to corporate-ownedlife insurance (“COLI”) policies. Grace reached an agreement with the IRS withrespect to all proposed tax adjustments in the Examination Report (includingsettlement of COLI) with the exception of approximately $7.0 million ofproposed adjustments relating to research and development credits. On April 14,2005, Grace made a $90 million payment to the IRS with respect to federal taxesand accrued interest for the 1993-1996 tax periods, consistent with the revisedExamination Report. On June 17, 2005, Grace filed its protest with respect tothe R&D matter with the IRS Office of Appeals.  Grace has been engaged in negotiations with the IRS with respect to thismatter during the second quarter of 2006.

As a consequenceof having determined federal tax adjustments for the 1990-1996 tax periods,Grace became liable for additional state taxes plus interest accrued thereon.Grace’s estimate for state taxes and interest to be paid for these years isapproximately $18.3 million, of which it has already paid approximately $6.3million. The remainder is expected to be paid in accordance with Grace’sbankruptcy proceedings.

In June 2006, Grace received revised examinationreports for the 1988-1989 and 1997-2001 tax periods, collectively, the “ExaminationReports” from the IRS asserting, in the aggregate, approximately $32.5 millionof net additional tax plus accrued interest. The most significant issue addressed in the Examination Reports concernsthe carryback of a specified liability loss from the 1998 tax period to the1989 taxable year.  Since Grace was in anet operating loss position for all but two of the other tax periods covered inthe audit, most of the other issues addressed in the Examination Reports ifdetermined adversely to Grace should not result in any cash tax liability butrather would impact the amount of certain tax attributes claimed by Grace inthose tax periods such as losses and credits. On May 25, 2006, Grace  filed aprotest with the IRS Office of Appeals with respect to the ten year carrybackissue as well as certain computational issues.

Grace’s federal tax returns covering 2002 and lateryears are open for future examination by the IRS. Grace believes that itsrecorded tax liability is adequate to cover the impact of probable tax returnadjustments at June 30, 2006.

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. The assessments, aggregating $61.9 million, weremade in connection with a meal and incidental expense per diem plan fortraveling health care personnel, which was in effect through 1999, the year inwhich Grace sold the business.  (Thestatute of limitations has expired with respect to 1999.) The IRS contends thatcertain per diem reimbursements should have been treated as wages subject toemployment taxes and federal income tax withholding. Grace contends that itsper diem and expense allowance plans were in accordance with statutory andregulatory requirements, as well as other published guidance from the IRS.Grace has a right to indemnification from its former partner in the businessfor approximately 36% of any tax liability (including interest thereon) for theperiod from July 1996 through December 1998. The matter is currently pending inthe United States Court of Claims. Grace has agreed with the Department ofJustice and the IRS on a settlement amount and certain other terms that wouldresolve the matter.  The settlement issubject to the execution of written closing agreements with the IRS and theDepartment of Justice, and to Bankruptcy Court approval.  Grace believes that its recorded taxliability is adequate to cover the impact of this matter at June 30, 2006.

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Under federal income tax law, a corporation isgenerally permitted to deduct from taxable income in any year net operatinglosses (“NOL”) carried forward from prior years.  Grace’s ability to deduct NOL carryforwardscould be subject to a significant limitation if it were to undergo an ownershipchange for purposes of Section 382 of the Internal Revenue Code of 1986, asamended, during or as a result of its Chapter 11 cases.  During the course of the bankruptcyproceeding, the Bankruptcy Court entered an order that places certainlimitations on trading in Grace’s common stock or options convertible intocommon stock.  Pursuant to theselimitations, the Company intends to object to any purchase of the Company’sstock or options that would potentially contribute to an “ownership change” forpurposes of Section 382.  However, Gracecan provide no assurance that these limitations will prevent an ownershipchange or that our ability to utilize net operating loss carryforwards may notbe significantly limited as a result of Grace’s reorganization.

***Purchase Commitments***— Grace engagesin purchase commitments to minimize the volatility of major components ofdirect manufacturing costs including natural gas, certain metals, asphalt,amines and other materials.  Suchcommitments are for quantities that Grace fully expects to use in its normaloperations.

***Guarantees and Indemnification Obligations* **—****Graceis a party to many contracts containing guarantees and indemnificationobligations. 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 otherservice providers in which Grace has agreed to indemnify such parties againstcertain liabilities in connection with their performance. Based on historicalexperience and the likelihood that such parties will ever make a claim againstGrace, such indemnification 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*******—Financial assurances have been established for a variety of purposes, includinginsurance and environmental matters, asbestos settlements and appeals,trade-related commitments and other matters. At June 30, 2006, Grace had gross financial assurances issued and outstandingof $267.4 million, comprised of $135.0 million of surety bonds issued byvarious insurance companies, and $132.4 million of standby letters of creditand other financial assurances issued by various banks. As discussed in Note 8,$42.1 million of these financial assurances have been issued under the DIPfacility.

***Accounting for Contingencies*******—****Although theoutcome of each of the matters discussed above cannot be predicted withcertainty, Grace has assessed its risk and has made accounting estimates asrequired under U.S. generally accepted accounting principles. As a result ofthe Filing, claims related to certain of the items discussed above will beaddressed as part of Grace’s Chapter 11 proceedings. Accruals recorded for suchcontingencies have been included in “liabilities subject to compromise” in theaccompanying Consolidated Balance Sheets. The amounts of these liabilities asultimately determined through the Chapter 11 proceedings could be materiallydifferent from amounts recorded at June 30, 2006.

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**13.****             Pension Plans andOther Postretirement Benefit Plans**

***Pension Plans***— Grace maintains defined benefit pension planscovering employees of certain units who meet age and service requirements.Benefits are generally based on final average salary and years of service.Grace funds its U.S. qualified pension plans (“U.S. qualified pension plans”)in accordance with U.S. federal laws and regulations. Non-U.S. pension plans (“non-U.S.pension plans”) are funded under a variety of methods, as required under locallaws 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, 2005measurement date for Grace’s defined benefit pension plans (the “Plans”), theaccumulated benefit obligation (“ABO”) was approximately $1,386 million asmeasured under U.S. generally accepted accounting principles. At June 30, 2006,Grace’s recorded pension liability for underfunded plans was $533.7 million($445.5 million included in liabilities not subject to compromise and $88.2million related to supplemental pension benefits, included in “liabilitiessubject to compromise”). The recorded liability reflects 1) the shortfallbetween dedicated assets and the ABO of underfunded plans ($310.3 million); and2) the ABO of pay-as-you-go plans ($223.4 million).

***Postretirement Benefits Other Than Pensions*** —****Graceprovides postretirement health care and life insurance benefits (referred to asother post-employment benefits or “OPEB”) for retired employees of certain U.S.business units and certain divested units. The postretirement medical plan provides various levels of benefits toemployees hired before 1991 and who retire from Grace after age 55 with atleast 10 years of service.  These plansare unfunded and Grace pays a portion of the costs of benefits under theseplans as they are incurred. Grace applies SFAS No. 106, “Employers’ Accountingfor Postretirement Benefits Other Than Pensions,” which requires that thefuture costs of postretirement health care and life insurance benefits beaccrued over the employees’ years of service.

Retirees andbeneficiaries covered by the postretirement medical plan are required tocontribute a minimum of 40% of the calculated premium for that coverage. During2002, per capita costs under the retiree medical plans exceeded caps on theamount Grace was required to contribute under a 1993 amendment to the plan. Asa result, for 2003 and future years, retirees will bear 100% of any increase inpremium 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 decreasegradually to 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) forthe three months and six months ended June 30, 2006 and 2005 are as follows:

 
| **Components of Net Periodic Benefit Cost (Income) ***(In millions)* | ** ** | **Three Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                   | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| ** **                                                                                                   | ** ** | **Pension**                                         | ** ** | ** ** | ** ** | **Pension** | ** ** | ** ** | ** ** |
| ** **                                                                                                   | ** ** | **U.S.**                                            | ** ** | **Non-U.S.** | ** ** | **OPEB** | ** ** | **U.S.** | ** ** | **Non-U.S.** | ** ** | **OPEB** | ** ** |
| Service cost                                                                                                 | ** ** | **$**                                               | **3.8**    | ** ** | **$** | **2.1** | ** ** | **$** | **0.1** |   | $ | 4.0 |   | $ | 1.9 |   | $ | 0.2 |   |
| Interest cost                                                                                                | ** ** | **14.6**                                            | ** ** | **4.3** | ** ** | **0.9** |   | 14.6 |   | 4.3 |   | 1.2 |   |
| Expected return  on plan assets                                                                              | ** ** | **(12.6**                                           | **)**      | **(4.5** | **)** | **—** |   | (12.8 | ) | (3.9 | ) | — |   |
| Amortization of  prior service cost                                                                          | ** ** | **0.6**                                             | ** ** | **0.2** | ** ** | **(2.0** | **)** | 1.3 |   | 0.2 |   | (3.2 | ) |
| Amortization of  unrecognized actuarial loss                                                                 | ** ** | **6.2**                                             | ** ** | **2.1** | ** ** | **(0.2** | **)** | 6.3 |   | 1.9 |   | 0.4 |   |
| Net curtailment  and settlement loss                                                                         | ** ** | **—**                                          | ** ** | **—** | ** ** | **—** |   | 0.1 |   | 1.6 |   | — |   |
| **Net periodic benefit cost  (income)**                                                                      | ** ** | **$**                                               | **12.6**   | ** ** | **$** | **4.2** | ** ** | **$** | **(1.2** | **)** | $ | 13.5 |   | $ | 6.0 |   | $ | (1.4 | ) |

 

I-27

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| **Components of Net Periodic Benefit Cost (Income)***(In millions)* | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                             | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| ** **                                                                                             | ** ** | **Pension**                                       | ** ** | ** ** | ** ** | **Pension** | ** ** | ** ** | ** ** |
| ** **                                                                                             | ** ** | **U.S.**                                          | ** ** | **Non-U.S.** | ** ** | **OPEB** | ** ** | **U.S.** | ** ** | **Non-U.S.** | ** ** | **OPEB** | ** ** |
| Service cost                                                                                           | ** ** | **$**                                             | **8.1**    | ** ** | **$** | **4.1** | ** ** | **$** | **0.2** |   | $ | 8.2 |   | $ | 3.8 |   | $ | 0.4 |   |
| Interest cost                                                                                          | ** ** | **29.1**                                          | ** ** | **8.5** | ** ** | **2.0** |   | 29.0 |   | 8.7 |   | 2.4 |   |
| Expected return  on plan assets                                                                        | ** ** | **(26.5**                                         | **)**      | **(8.8** | **)** | **—** |   | (25.6 | ) | (7.9 | ) | — |   |
| Amortization of  prior service cost                                                                    | ** ** | **1.2**                                           | ** ** | **0.3** | ** ** | **(5.2** | **)** | 2.6 |   | 0.4 |   | (6.4 | ) |
| Amortization of  unrecognized actuarial loss                                                           | ** ** | **11.5**                                          | ** ** | **4.1** | ** ** | **0.2** |   | 11.4 |   | 3.8 |   | 0.8 |   |
| Net curtailment  and settlement loss                                                                   | ** ** | **—**                                        | ** ** | **—** | ** ** | **—** |   | 1.1 |   | 1.6 |   | — |   |
| **Net periodic benefit cost  (income)**                                                                | ** ** | **$**                                             | **23.4**   | ** ** | **$** | **8.2** | ** ** | **$** | **(2.8** | **)** | $ | 26.7 |   | $ | 10.4 |   | $ | (2.8 | ) |

 

***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 $106 million for the period from July 2006 through January2007.  In that regard, Grace contributedapproximately $20 million in July 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.****             Operating SegmentInformation**

Grace is a globalproducer of specialty chemicals and materials. It generates revenues from twooperating segments: Grace Davison, which includes silica- and alumina-basedcatalysts and materials used in a wide range of industrial applications; andGrace Performance Chemicals, which includes specialty chemicals and materials usedin commercial and residential construction and in rigid food and beveragepackaging. Intersegment sales, eliminated in consolidation, are notmaterial.  The table below presentsinformation related to Grace’s operating segments for the three months and sixmonths ended June 30, 2006 and 2005, respectively. Only those corporateexpenses directly related to the operating segments are allocated for reportingpurposes. All remaining corporate items are reported separately and labeled assuch.
| **Operating Segment Data***(In millions)* | ** ** | **Three Months  Ended  June 30,** | ** ** | **Six Months  Ended  June 30,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                               | ** ** | **2006**                                    | ** ** | **2005**                                  | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Net  Sales**                                           |       |                                        |       |                                      |       |   |   |   |   |
| Grace Davison                                            | ** ** | **$**                                       | **380.3**  |                                      | $          | 358.9 | ** ** | **$** | **736.7** |   | $ | 693.6 |   |
| Grace  Performance Chemicals                             | ** ** | **348.8**                                   |       | 317.6                                     | ** ** | **651.0** |   | 586.1 |   |
| **Total**                                                | ** ** | **$**                                       | **729.1**  |                                      | $          | 676.5 | ** ** | **$** | **1,387.7** |   | $ | 1,279.7 |   |
| **Pre-tax  Operating Income**                            |       |                                        |       |                                      |       |   |   |   |   |
| Grace Davison                                            | ** ** | **$**                                       | **46.3**   |                                      | $          | 43.1 | ** ** | **$** | **82.3** |   | $ | 80.8 |   |
| Grace  Performance Chemicals                             | ** ** | **53.1**                                    |       | 45.7                                      | ** ** | **87.3** |   | 73.0 |   |
| Corporate costs                                          | ** ** | **(28.7**                                   | **)**      | (32.2                                     | )          | **(51.1** | **)** | (57.5 | ) |
| **Total**                                                | ** ** | **$**                                       | **70.7**   |                                      | $          | 56.6 | ** ** | **$** | **118.5** |   | $ | 96.3 |   |

 

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 six months ended June 30, 2006 and 2005,respectively.
| **Geographic Area Data***(In millions)* | ** ** | **Three Months  Ended  June 30,** | ** ** | **Six Months  Ended  June 30,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                             | ** ** | **2006**                                    | ** ** | **2005**                                  | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Net Sales**                                          |       |                                        |       |                                      |       |   |   |   |   |
| United States                                          | ** ** | **$**                                       | **267.5**  |                                      | $          | 249.0 | ** ** | **$** | **506.8** |   | $ | 475.9 |   |
| Canada and  Puerto Rico                                | ** ** | **25.5**                                    |       | 31.9                                      | ** ** | **66.1** |   | 65.2 |   |
| Total North  America                                   | ** ** | **$**                                       | **293.0**  |                                      | $          | 280.9 | ** ** | **$** | **572.9** |   | $ | 541.1 |   |
| Germany                                                | ** ** | **35.1**                                    |       | 30.0                                      | ** ** | **65.4** |   | 58.5 |   |
| Europe, other  than Germany                            | ** ** | **233.9**                                   |       | 214.7                                     | ** ** | **450.6** |   | 407.4 |   |
| Total Europe                                           | ** ** | **$**                                       | **269.0**  |                                      | $          | 244.7 | ** ** | **$** | **516.0** |   | $ | 465.9 |   |
| Asia Pacific                                           | ** ** | **128.4**                                   |       | 117.6                                     | ** ** | **226.7** |   | 205.7 |   |
| Latin America                                          | ** ** | **38.7**                                    |       | 33.3                                      | ** ** | **72.1** |   | 67.0 |   |
| **Total**                                              | ** ** | **$**                                       | **729.1**  |                                      | $          | 676.5 | ** ** | **$** | **1,387.7** |   | $ | 1,279.7 |                                |

 

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The pre-taxoperating income for Grace’s operating segments for the three months and sixmonths ended June 30, 2006 and 2005, respectively, is reconciled below toincome (loss) before Chapter 11 expenses, income taxes, and minority interestpresented in the accompanying Consolidated Statements of Operations.

 
| **Reconciliation of Operating Segment Data to Financial Statements***(In millions)* | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                                                  | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Pre-tax  operating income — core operations                                                                            | ** ** | **$**                                           | **70.7**   |                                          | $          | 56.6 | ** ** | **$** | **118.5** |   | $ | 96.3 |   |
| Minority  interest                                                                                                          | ** ** | **11.5**                                        |       | 7.5                                           | ** ** | **18.3** |   | 11.0 |   |
| Net gain (loss)  on sales of investments and disposals of assets                                                            | ** ** | **4.6**                                         |       | (0.4                                          | )          | **2.8** |   | 0.5 |   |
| Provision for  environmental remediation                                                                                    | ** ** | **(30.0**                                       | **)**      | —                                        | ** ** | **(30.0** | **)** | — |   |
| Interest expense  and related financing costs                                                                               | ** ** | **(19.9**                                       | **)**      | (13.3                                         | )          | **(35.7** | **)** | (27.9 | ) |
| Other, net                                                                                                                  | ** ** | **(15.8**                                       | **)**      | 14.4                                          | ** ** | **(32.7** | **)** | 6.1 |   |
| Income (loss) before  Chapter 11 expenses, income taxes, and minority   interest                                            | ** ** | **$**                                           | **21.1**   |                                          | $          | 64.8 | ** ** | **$** | **41.2** |   | $ | 86.0 |   |

 

Minority interestprimarily pertains to Advanced Refining Technologies LLC (“ART”), a jointventure between Grace and Chevron Products Company where Grace has a 55%economic interest.

 

I-29

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**Item2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

**Financial Summaryfor June 30, 2006**

Following is a summary analysis of key financial measures of ourperformance for the three months and six months ended June 30, 2006 comparedwith the prior year periods.

 

·                     Salesincreased 7.8% and 8.4% for the three months and six months ended June 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 results of ourbusinesses – which is categorized as “core operations”; and 2) the impact oflegal contingencies and other nonoperating liabilities – which is categorizedas “noncore activities”.

·                     Netloss was $5.2 million for the three months ended June 30, 2006, compared withnet income of $32.7 million for the three months ended June 30, 2005.  Net loss was $5.1 million for the six monthsended June 30, 2006, compared with net income of $35.8 for the six months endedJune 30, 2005.  The second quarter andyear-to-date net loss is attributable to a $30.0 million increase in theestimated liability for environmental remediation, principally related to theformer vermiculite mining operation in Montana, and to $24.3 million ($53.1million for the six months ended June 30, 2006) of expense for Chapter 11,litigation and other matters not related to core operations.  

·                     Pre-taxincome from core operations increased 24.9% and 23.1% for the three months andsix months ended June 30, 2006, respectively, primarily attributable to highersales volume in all geographic regions and higher selling prices to partiallyoffset cost inflation, and from lower overall pension costs.

·                     Pre-taxoperating income of our Grace Performance Chemicals operating segment increased16.2% and 19.6% for the three months and six months ended June 30, 2006,respectively, attributable principally to higher sales of commercialconstruction products.

·                     Pre-taxoperating income of our Grace Davison operating segment increased 7.4% and 1.9%for the three months and six months ended June 30, 2006, respectively,attributable primarily to higher sales of specialty materials and catalystsused in refining, chemical, and industrial applications.

·                     Operatingcash flow for the six months ended June 30, 2006 was $11.1 million comparedwith a negative $74.6 million for the prior year period. The higher cash flowis attributable to improved operating results in 2006 and the non-recurrence of$119.7 million paid to settle tax and environmental contingencies in the prioryear period.

·                     Pre-taxloss from noncore activities was $42.8 million in the second quarter of 2006compared with pre-tax income of $13.1 million in the prior year quarter.  The pre-tax loss from noncore activities was$62.9 million year-to-date in 2006 compared with pre-tax income of $5.0 millionin the prior year period.  The secondquarter and year-to-date changes are principally due to revised estimates ofenvironmental remediation costs of $30.0 million, and higher legal defensecosts of $18.5 million, both related to issues arising from Grace’s formervermiculite mining operations in Montana. Pre-tax income from noncore activities in the prior year periods isprimarily attributable to gains recorded from insurance recoveries onpre-Chapter 11 environmental and asbestos-related costs.

We are attempting to resolve noncore liabilities and contingenciesthrough our Chapter 11 proceeding. Our noncore liabilities includeasbestos-related litigation, environmental remediation, tax disputes andbusiness litigation. Our operating statements include periodic adjustments toaccount for changes in estimates of such liabilities and developments in ourChapter 11 proceeding. These liabilities and contingencies may result incontinued volatility in net results in the future.

I-30

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**Descriptionof Core Business**

 

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

 

***Grace Davison***includes:

·                     Catalysts andchemical additives used by petroleum refiners, including fluid catalyticcracking, or FCC, catalysts, that help to “crack” the hydrocarbon chain indistilled crude oil to produce transportation fuels, such as gasoline anddiesel fuels, and other petroleum-based products, and FCC additives used toreduce sulfur in gasoline, maximize propylene production from refinery FCCunits, and reduce emissions of sulfur oxides, nitrogen oxides and carbonmonoxide from refinery FCC units;

·                     Hydroprocessingcatalysts used by petroleum refiners in process reactors to upgrade heavy oilsinto lighter, more useful products by removing impurities such as nitrogen,sulfur and heavy metals, allowing less expensive feedstocks to be used in thepetroleum refining process;

·                     Specialtycatalysts, including polyolefin catalysts and catalyst supports that areessential components in the manufacture of polyethylene and polypropyleneresins, and other chemical catalysts used in a variety of industrial,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;

·                    digital mediacoatings 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, or GPC,***includes:  

·                     Constructionmaterials and systems, including concrete admixtures and fibers used to improvethe durability and working properties of concrete, additives used in cementprocessing to improve energy efficiency and enhance the characteristics offinished cement, waterproofing materials used in commercial and residentialconstruction and renovation to protect buildings from water penetration, andfireproofing materials used to protect buildings from structural failure in theevent of fire; and

·                     Packagingtechnologies, primarily specialty sealants and coatings used in rigid food andbeverage packages, including can and closure sealants used to seal and enhancethe shelf life of can and bottle contents, and coatings for cans and closuresthat prevent metal corrosion, protect package contents from the influence ofmetal and ensure proper adhesion of sealing compounds.

Constructionproducts sales are affected by non-residential construction activity and, to alesser extent, 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 are in the U.S., so we arestrongly influenced by the level of U.S. construction activity.

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Our packaging technologies sales are affected by general economicconditions globally as well as an ongoing shift in demand from metal and glassto plastic packaging for foods and beverages. This shift is causing a declinein can sealant usage, but provides opportunities for closure sealants and otherproducts for plastic packaging.

 

***Global scope*** – We operate our business on aglobal scale with more than 60% of our revenue and 40% of our operatingproperties outside the United States. Our business is conducted in more than 40countries and in more than 20 currencies. Our operating segments are managed ona global basis, serving global markets, with currency fluctuations in relationto the U.S. dollar affecting reported earnings, net assets and cash flows.

 

The table below shows the sales in each of our operating segments, anddomestic and international sales, as a percentage of our total sales.

 
| **Percentage of  Total Grace Sales** | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                           | ** ** | **2006**                        | ** ** | **2005**                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Grace Davison                        |       | **52.2**                        | **%**      | 53.0                          | %          | **53.1** | **%** | 54.2 | % |
| Grace  Performance Chemicals         |       | **47.8**                        | **%**      | 47.0                          | %          | **46.9** | **%** | 45.8 | % |
| **Total**                            |       | **100.0**                       | **%**      | 100.0                         | %          | **100.0** | **%** | 100.0 | % |
| Grace U.S.                           |       | **36.7**                        | **%**      | 36.8                          | %          | **36.5** | **%** | 37.2 | % |
| Grace non-U.S.                       |       | **63.3**                        | **%**      | 63.2                          | %          | **63.5** | **%** | 62.8 | % |
| **Total**                            |       | **100.0**                       | **%**      | 100.0                         | %          | **100.0** | **%** | 100.0 | % |

 

**VoluntaryBankruptcy Filing**

In response to a sharply increasing number of asbestos-related personalinjury claims, on April 2, 2001, Grace and 61 of our United States subsidiariesand affiliates, including W. R. Grace & Co. – Conn., filed voluntarypetitions for reorganization under Chapter 11 of the United States BankruptcyCode in the United States Bankruptcy Court for the District of Delaware. Ournon-U.S. subsidiaries and certain of our U.S. subsidiaries were not included inthe Chapter 11 filing.

 

Under Chapter 11, we have continued to operate 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 Chapter 11 filing, all motions necessary to conduct normalbusiness activities have been approved by the bankruptcy court. 

 

On January 13, 2005, we filed an amended plan of reorganization andrelated documents with the bankruptcy court. The plan of reorganization issupported by committees representing general unsecured creditors and equityholders, but is not supported by committees representing asbestos personalinjury claimants and asbestos property damage claimants. Under the terms of theplan of reorganization, a trust would be established to which all pending andfuture asbestos-related claims would be channeled for resolution. The plan ofreorganization can become effective only after a vote of eligible creditors andwith the approval of the bankruptcy court and the U.S. District Court for theDistrict of Delaware. See “Plan of Reorganization” below for more information.

** **

**CriticalAccounting Estimates**

The preparation of financial statements in conformity with U.S.generally accepted accounting principles requires that we make estimates andassumptions affecting the assets and liabilities reported at the date of theConsolidated Financial Statements, and the revenues and expenses reported forthe periods presented. Actual amounts could differ from those estimates.Changes in estimates are recorded in the period identified. Accountingmeasurements that are most affected by our estimates of future events and aredeemed to be critical accounting estimates by 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), and litigation(see Note 12 to the Consolidated Financial Statements);

·                     Pension andpostretirement liabilities that depend on assumptions regarding discount ratesand total returns on invested funds (see Note 13 to the Consolidated FinancialStatements);

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

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·                     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 of these and other estimates may also be materially affectedby the uncertainties arising under our Chapter 11 proceeding.

 

**Summary FinancialInformation and Metrics**

Set forth on the next page is a chart that lists our key operatingstatistics, and dollar and percentage changes for the three months and six monthsended June 30, 2006 and 2005. Please refer to this chart when readingmanagement’s discussion and analysis of financial condition and results ofoperations. 

 

 

 

I-33

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| ** **                                                                              | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| **Analysis of Continuing Operations***(In millions)*                | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **$ Change   Fav  (Unfav)** | ** ** | **% Change  Fav  (Unfav)** | ** ** | **2006** | ** ** | **2005** | ** ** | **$ Change  Fav   (Unfav)** | ** ** | **% Change  Fav  (Unfav)** | ** ** |
| **Net sales:**                                                                          |       |                                                |       |                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Grace Davison                                                                           |       | **$**                                               | **380.3**  | ** **                                        | $          | 358.9 |   | $ | 21.4 |   | 6.0 | % | **$** | **736.7** | ** ** | $ | 693.6 |   | $ | 43.1 |   | 6.2 | % |
| Grace Performance Chemicals                                                             |       | **348.8**                                           | ** ** | 317.6                                             |       | 31.2 |   | 9.8 | % | **651.0** | ** ** | 586.1 |   | 64.9 |   | 11.1 | % |
| **Total Grace net sales**                                                               |       | **$**                                               | **729.1**  | ** **                                        | $          | 676.5 |   | $ | 52.6 |   | 7.8 | % | **$** | **1,387.7** | ** ** | $ | 1,279.7 |   | $ | 108.0 |   | 8.4 | % |
| **Pre-tax operating income:**                                                           |       | ** **                                          | ** ** |                                              |       |   |   |   |   | ** ** | ** ** |   |   |   |   |   |   |
| Grace Davison (1)                                                                       |       | **$**                                               | **46.3**   | ** **                                        | $          | 43.1 |   | $ | 3.2 |   | 7.4 | % | **$** | **82.3** | ** ** | $ | 80.8 |   | $ | 1.5 |   | 1.9 | % |
| Grace Performance Chemicals                                                             |       | **53.1**                                            | ** ** | 45.7                                              |       | 7.4 |   | 16.2 | % | **87.3** | ** ** | 73.0 |   | 14.3 |   | 19.6 | % |
| Corporate costs:                                                                        |       | ** **                                          | ** ** |                                              |       |   |   |   |   | ** ** | ** ** |   |   |   |   |   |   |
| Support functions                                                                       |       | **(11.3**                                           | **)**      | (9.7                                              | )          | (1.6 | ) | (16.5 | %) | **(22.0** | **)** | (19.2 | ) | (2.8 | ) | (14.6 | %) |
| Pension, performance-related  compensation, and other                                   |       | **(17.4**                                           | **)**      | (22.5                                             | )          | 5.1 |   | 22.7 | % | **(29.1** | **)** | (38.3 | ) | 9.2 |   | 24.0 | % |
| Total Corporate costs                                                                   |       | **(28.7**                                           | **)**      | (32.2                                             | )          | 3.5 |   | 10.9 | % | **(51.1** | **)** | (57.5 | ) | 6.4 |   | 11.1 | % |
| **Pre-tax income from core  operations**                                                |       | **70.7**                                            | ** ** | 56.6                                              |       | 14.1 |   | 24.9 | % | **118.5** | ** ** | 96.3 |   | 22.2 |   | 23.1 | % |
| **Pre-tax income (loss)  from noncore activities**                                      |       | **(42.8**                                           | **)**      | 13.1                                              |       | (55.9 | ) | NM |   | **(62.9** | **)** | 5.0 |   | (67.9 | ) | NM |   |
| Interest expense                                                                        |       | **(19.9**                                           | **)**      | (13.3                                             | )          | (6.6 | ) | (49.6 | %) | **(35.7** | **)** | (27.9 | ) | (7.8 | ) | (28.0 | %) |
| Interest income                                                                         |       | **1.6**                                             | ** ** | 0.9                                               |       | 0.7 |   | 77.8 | % | **3.0** | ** ** | 1.6 |   | 1.4 |   | 87.5 | % |
| **Income (loss) before  Chapter 11 expenses and income taxes**                          |       | **9.6**                                             | ** ** | 57.3                                              |       | (47.7 | ) | (83.2 | %) | **22.9** | ** ** | 75.0 |   | (52.1 | ) | (69.5 | %) |
| Chapter 11 expenses, net                                                                |       | **(11.5**                                           | **)**      | (4.6                                              | )          | (6.9 | ) | (150.0 | %) | **(20.2** | **)** | (10.6 | ) | (9.6 | ) | (90.6 | %) |
| Benefit from (provision  for) income taxes                                              |       | **(3.3**                                            | **)**      | (20.0                                             | )          | 16.7 |   | 83.5 | % | **(7.8** | **)** | (28.6 | ) | 20.8 |   | 72.7 | % |
| **Net income (loss)**                                                                   |       | **$**                                               | **(5.2**   | **)**                                             | $          | 32.7 |   | $ | (37.9 | ) | (115.9 | %) | **$** | **(5.1** | **)** | $ | 35.8 |   | $ | (40.9 | ) | (114.2 | %) |
| **Key Financial Measures:**                                                             |       | ** **                                          | ** ** |                                              |       |   |   |   |   | ** ** | ** ** |   |   |   |   |   |   |
| **Pre-tax income from core operations as a percentage of sales:**                       |       | ** **                                          | ** ** |                                              |       |   |   |   |   | ** ** | ** ** |   |   |   |   |   |   |
| Grace Davison                                                                           |       | **12.2**                                            | **%**      | 12.0                                              | %          | NM |   | 0.2  pts |   | **11.2** | **%** | 11.6 | % | NM |   | (0.4)  pts |   |
| Grace Performance Chemicals                                                             |       | **15.2**                                            | **%**      | 14.4                                              | %          | NM |   | 0.8  pts |   | **13.4** | **%** | 12.5 | % | NM |   | 0.9  pts |   |
| Total Core Operations                                                                   |       | **9.7**                                             | **%**      | 8.4                                               | %          | NM |   | 1.3  pts |   | **8.5** | **%** | 7.5 | % | NM |   | 1.0  pts |   |
| Total Core Operations  adjusted for profit sharing of joint ventures (2)                |       | **11.3**                                            | **%**      | 9.5                                               | %          | NM |   | 1.8  pts |   | **9.9** | **%** | 8.4 | % | NM |   | 1.5  pts |   |
| **Pre-tax income from core  operations before depreciation and amortization**           |       | **$**                                               | **99.1**   | ** **                                        | $          | 86.8 |   | $ | 12.3 |   | 14.2 | % | **$** | **175.0** | ** ** | $ | 157.0 |   | $ | 18.0 |   | 11.5 | % |
| **As a percentage of sales**                                                            |       | **13.6**                                            | **%**      | 12.8                                              | %          | NM |   | 0.8  pts |   | **12.6** | **%** | 12.3 | % | NM |   | 0.3  pts |   |
| **Depreciation and  amortization**                                                      |       | **$**                                               | **28.4**   | ** **                                        | $          | 30.2 |   | $ | 1.8 |   | 6.0 | % | **$** | **56.5** | ** ** | $ | 60.7 |   | $ | 4.2 |   | 6.9 | % |
| **Gross profit percentage (sales less cost of goods sold as a percent  of sales) (3):** |       | ** **                                          | ** ** |                                              |       |   |   |   |   | ** ** | ** ** |   |   |   |   |   |   |
| Grace Davison                                                                           |       | **30.7**                                            | **%**      | 30.1                                              | %          | NM |   | 0.6  pts |   | **29.5** | **%** | 30.3 | % | NM |   | (0.8)  pts |   |
| Grace Performance Chemicals                                                             |       | **35.4**                                            | **%**      | 34.6                                              | %          | NM |   | 0.8  pts |   | **34.5** | **%** | 33.9 | % | NM |   | 0.6  pts |   |
| Total Grace                                                                             |       | **32.8**                                            | **%**      | 31.9                                              | %          | NM |   | 0.9  pts |   | **31.7** | **%** | 31.6 | % | NM |   | 0.1  pts |   |
| **Net Consolidated Sales by Region**:                                                   |       | ** **                                          | ** ** |                                              |       |   |   |   |   | ** ** | ** ** |   |   |   |   |   |   |
| North America                                                                           |       | **$**                                               | **293.0**  | ** **                                        | $          | 280.9 |   | $ | 12.1 |   | 4.3 | % | **$** | **572.9** | ** ** | $ | 541.1 |   | $ | 31.8 |   | 5.9 | % |
| Europe                                                                                  |       | **269.0**                                           | ** ** | 244.7                                             |       | 24.3 |   | 9.9 | % | **516.0** | ** ** | 465.9 |   | 50.1 |   | 10.8 | % |
| Asia Pacific                                                                            |       | **128.4**                                           | ** ** | 117.6                                             |       | 10.8 |   | 9.2 | % | **226.7** | ** ** | 205.7 |   | 21.0 |   | 10.2 | % |
| Latin America                                                                           |       | **38.7**                                            | ** ** | 33.3                                              |       | 5.4 |   | 16.2 | % | **72.1** | ** ** | 67.0 |   | 5.1 |   | 7.6 | % |
| **Total**                                                                               |       | **$**                                               | **729.1**  | ** **                                        | $          | 676.5 |   | $ | 52.6 |   | 7.8 | % | **$** | **1,387.7** | ** ** | $ | 1,279.7 |   | $ | 108.0 |   | 8.4 | % |

 

----

NM = Not meaningful

(1)             GraceDavison pre-tax operating income includes minority interest related to theAdvanced Refining Technologies joint venture.

(2)             Reflectsthe add-back of minority interests in consolidated subsidiaries.

(3)             Includesdepreciation and amortization related to manufacturing of products.

 

In the above chart, as well as in the financial information presentedthroughout this discussion, we present our financial results in the same manneras results are reviewed internally.  Webreak 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 “Pretax 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-tax income from core operations, pre-tax income (loss) from noncoreactivities, pre-tax income from core operations as a percentage of sales, andpre-tax income from core operations before depreciation and amortization do notpurport to represent income or cash flow measures as defined under 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, including the effect of our Chapter 11 proceedings, and toensure that you understand the key data that management uses to evaluate ourresults of operations. 

 

I-34

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**Grace Overview**

The following is an overview of our financial performance for the threemonths and six months ended June 30, 2006 compared with the prior year periods.

***Net Sales***—****Thefollowing tables identify the period-over-period increase or decrease in salesattributable to changes in product volume, product price and/or mix, and theimpact of foreign currency translation.

 
| **Net Sales  Variance Analysis** | ** ** | **Three Months Ended June 30, 2006 as a Percentage  Increase (Decrease) from  Three Months Ended June 30, 2005** | ** ** |
|--------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **Volume**                                                                                                                                                                                  | ** ** | **Price/Mix** | ** ** | **Currency  Translation** | ** ** | **Total** | ** ** |
| Grace Davison                              |       | 1.3                                                                                                                                                                                         | %          | 5.7 | % | (1.0 | %) | 6.0 | % |
| Grace  Performance Chemicals               |       | 6.5                                                                                                                                                                                         | %          | 3.7 | % | (0.4 | %) | 9.8 | % |
| Net sales                                  |       | 3.7                                                                                                                                                                                         | %          | 4.8 | % | (0.7 | %) | 7.8 | % |
| **By Region:**                             | ** ** | ** **                                                                                                                                                                                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| North America                              |       | (3.3                                                                                                                                                                                        | %)         | 7.2 | % | 0.4 | % | 4.3 | % |
| Europe                                     |       | 9.4                                                                                                                                                                                         | %          | 3.1 | % | (2.6 | %) | 9.9 | % |
| Asia Pacific                               |       | 7.7                                                                                                                                                                                         | %          | 1.6 | % | (0.1 | %) | 9.2 | % |
| Latin America                              |       | 15.3                                                                                                                                                                                        | %          | (1.2 | %) | 2.1 | % | 16.2 | % |

 

Sales for thethree months ended June 30, 2006 were favorably impacted by higher volume(including acquisitions), product mix, and selling price increases in responseto cost inflation. Acquisitions contributed $1.8 million or 0.3 percentagepoints of the sales growth.

 
| **Net Sales  Variance Analysis** | ** ** | **Six Months Ended June 30, 2006 as a Percentage  Increase (Decrease) from  Six Months Ended June 30, 2005** | ** ** |
|--------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **Volume**                                                                                                                                                                              | ** ** | **Price/Mix** | ** ** | **Currency  Translation** | ** ** | **Total** | ** ** |
| Grace Davison                              |       | 3.4                                                                                                                                                                                     | %          | 5.1 | % | (2.3 | %) | 6.2 | % |
| Grace  Performance Chemicals               |       | 8.4                                                                                                                                                                                     | %          | 4.3 | % | (1.6 | %) | 11.1 | % |
| Net sales                                  |       | 5.7                                                                                                                                                                                     | %          | 4.7 | % | (2.0 | %) | 8.4 | % |
| **By Region:**                             | ** ** | ** **                                                                                                                                                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| North America                              |       | 0.3                                                                                                                                                                                     | %          | 5.3 | % | 0.3 | % | 5.9 | % |
| Europe                                     |       | 12.1                                                                                                                                                                                    | %          | 4.6 | % | (5.9 | %) | 10.8 | % |
| Asia Pacific                               |       | 8.6                                                                                                                                                                                     | %          | 2.2 | % | (0.6 | %) | 10.2 | % |
| Latin America                              |       | 4.0                                                                                                                                                                                     | %          | 0.9 | % | 2.7 | % | 7.6 | % |

 

Sales for the six monthsended June 30, 2006 were favorably impacted by higher volume (includingacquisitions), product mix, and selling price increases in response to costinflation. Acquisitions contributed $2.7 million or 0.2 percentage points ofthe sales growth.

***Pre-tax Income from Core Operations***— Operating profit for the three monthsand six months ended June 30, 2006 improved due to sales volume growth andselling price increases, partially offset by raw material cost inflation.

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 three months and sixmonths ended June 30, 2006 decreased compared with the prior year periodsprimarily due to lower pension expense from the effect of contributions made todefined benefit 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 17% lower for the six monthsended June 30, 2006 and 1% lower for the six months ended June 30, 2005 (6%higher for all of 2005). The significant change in inventory valuations betweenFIFO and LIFO relate primarily to the price volatility, over the past severalquarters, of commodity metals and natural gas used in our Davison products andproduction processes.  We attempt tomitigate the price volatility through hedging techniques such as layering ourneeded supply under fixed delivery contracts, entering into commodity optionand swap contracts with suppliers and financial institutions, and bynegotiating sales contracts that permit the partial pass-through of marketprices for these volatile commodity items.

***Pre-tax Income (Loss) fromNoncore Activities***—****Pre-tax income (loss) from noncore activitiesreflects financial matters unrelated to our core operating units.  This category of costs and income is expectedto be volatile as potentially material items are addressed through our Chapter11 proceedings and/or as the financial implications of our legal contingenciesbecome apparent. Some noncore activities are shown as separate items in theConsolidated Statements of Operations. Those not separately listed are primarily included in selling, generaland administrative expenses and in other (income) expense. The following tableshows the components of noncore activities:

I-35

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| **Pre-tax Income (Loss) from Noncore Activities***(In millions)* | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                     | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Provision for  environmental remediation — vermiculite                                    | ** ** | **$**                                           | **(29.4**  | **)**                                         | $          | — | ** ** | **$** | **(29.4** | **)** | $ | — |   |
| Provision for  environmental remediation — other sites                                    | ** ** | **(0.6**                                        | **)**      | —                                        | ** ** | **(0.6** | **)** | — |   |
| Insurance settlements  — environmental and asbestos-related                               | ** ** | **6.9**                                         |       | 20.3                                          | ** ** | **6.9** |   | 20.3 |   |
| Asbestos  administration                                                                       | ** ** | **(2.5**                                        | **)**      | (1.9                                          | )          | **(5.4** | **)** | (4.2 | ) |
| COLI income, net                                                                               | ** ** | **0.5**                                         |       | 0.6                                           | ** ** | **1.7** |   | 1.9 |   |
| D&O  insurance cost — portion related to Chapter 11                                   | ** ** | **(1.5**                                        | **)**      | (1.5                                          | )          | **(3.0** | **)** | (3.0 | ) |
| Pension and  postretirement benefit costs — divested businesses                           | ** ** | **(2.2**                                        | **)**      | (1.3                                          | )          | **(4.1** | **)** | (2.6 | ) |
| Translation  effects - intercompany loan                                                       | ** ** | **10.7**                                        |       | (16.5                                         | )          | **13.7** |   | (31.4 | ) |
| Value of  currency contracts                                                                   | ** ** | **(10.7**                                       | **)**      | 16.7                                          | ** ** | **(13.5** | **)** | 31.2 |   |
| Net gain on sale  of real estate                                                               | ** ** | **5.0**                                         |       | —                                        | ** ** | **5.0** |   | — |   |
| Stock  appreciation rights                                                                     | ** ** | **0.6**                                         |       | —                                        | ** ** | **(2.0** | **)** | — |   |
| Legal defense  costs                                                                           | ** ** | **(17.6**                                       | **)**      | (3.2                                          | )          | **(27.9** | **)** | (9.2 | ) |
| Other                                                                                          | ** ** | **(2.0**                                        | **)**      | (0.1                                          | )          | **(4.3** | **)** | 2.0 |   |
| **Total**                                                                                      | ** ** | **$**                                           | **(42.8**  | **)**                                         | $          | 13.1 | ** ** | **$** | **(62.9** | **)** | $ | 5.0 |   |

 

Changes to pre-taxincome (loss) from noncore activities were attributable primarily to: (1)increases in legal defense costs of $14.4 million and $18.7 million for thethree months and six months ended June 30, 2006, respectively, compared to theprior year periods, primarily related to the Montana legal proceeding (see Note12 to the Consolidated Financial Statements for more information), (2) a $30.0million increase in estimated costs in the 2006 periods for environmentalremediation primarily in Montana (see Note 12 to the Consolidated FinancialStatements for more information), and (3) $20.3 million received from insurancecarriers in the 2005 periods with respect to coverage for past environmentalremediation costs and asbestos-related liability under liquidation arrangementsor dispute settlements, as compared with $6.9 million in the 2006 periods.

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 our 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 and have varying ratesthat 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.  We expect to recover this settlement premium overtime as the contracts are settled at rates greater than the initial rates inthe May 2004 foreign currency forward contracts.  For the six months ended June 30, 2006, €29.3million of loan principal was repaid. For the three months and six months endedJune 30, 2006, respectively, $10.7 million and $13.5 million of contract losseswere recognized, offset by foreign currency gains of $10.7 million and $13.7million.  For the three months and sixmonths ended June 30, 2005, respectively, $16.7 million and $31.2 million ofcontract gains were recognized, offset by foreign currency losses of $16.5million and $31.4 million.

***Chapter 11 Expenses***—****Although we are unable to measure precisely the impact ofthe Chapter 11 proceedings on our overall financial performance, we incurcertain added costs that are directly attributable to operating in Chapter 11.Net Chapter 11 expenses consist primarily of legal, financial and consultingfees that we, and the three creditors’ committees, incur. They fluctuate withthe activity in our Chapter 11 proceedings.

Our pre-tax incomefrom core operations included expenses for Chapter 11 related compensationcharges of $6.2 million and $6.5 million for the three months ended June 30,2006 and 2005, respectively, and $9.4 million and $9.4 million for the sixmonths ended June 30, 2006 and 2005, respectively. Poor performance of Gracecommon stock in the period leading up to and after the Chapter 11 filing diminishedthe value of our stock option program as an incentive compensation tool forcurrent and prospective employees, which caused us to change our long-termincentive compensation from an equity-based to a cash-based program.

I-36

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**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 six months ended June 30, 2006 compared with the prioryear 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, at a rate of 6.09% perannum, compounded quarterly from April 2, 2001, the Chapter 11 filingdate, through December 31, 2005 and, beginning January 1, 2006, at the floatingprime rate as quoted by Bloomberg, adjusted for periodic changes, andcompounded quarterly.  The effectiverates were 7.90% and 7.66% for the three months and six months ended June 30,2006, respectively.

·                  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***—****Income tax benefit (provision) at thefederal corporate rate of 35% for the three months and six months ended June30, 2006 was $0.7 million and $(0.9) million, respectively, and for thecorresponding prior year periods was $(18.4) million and $(22.5) million,respectively.   The primary differencesbetween these amounts and the overall provision for income taxes is due tointerest on tax contingencies and the non-deductibility of certain Chapter 11expenses.

**Operating Segment Overview**

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

***Grace Davison***

***Three Months Ended June 30, 2006***
| ** **                                                 | ** ** | **Three Months Ended June 30,** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **Net Sales by Region***(In millions)* | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **$ Change  Fav (Unfav)** | ** ** | **% Change  Fav (Unfav)** | ** ** |
| North America                                              | ** ** | **$**                                               | **129.8**  |   | $ | 127.6 |   | $ | 2.2 |   | 1.7 | % |
| Europe                                                     | ** ** | **153.4**                                           |       | 143.0 |   | 10.4 |   | 7.3 | % |
| Asia Pacific                                               | ** ** | **81.8**                                            |       | 74.7 |   | 7.1 |   | 9.5 | % |
| Latin America                                              | ** ** | **15.3**                                            |       | 13.6 |   | 1.7 |   | 12.5 | % |
| **Total Grace Davison**                                    | ** ** | **$**                                               | **380.3**  |   | $ | 358.9 |   | $ | 21.4 |   | 6.0 | % |

 

*Sales*

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

·                  Selling price increases to partially offsetnatural gas and raw material cost inflation;

·                  Continued strong demand for catalysts usedto upgrade heavy crude oil; and

·                  Higher volume of materials used inindustrial and chemical applications from stronger economic activity, and ofmaterials used in pharmaceutical applications.

Saleswere up in all regions and major product lines due to strong demand from highlevels of economic activity.

I-37

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###### *Pre-tax Operating Income and Margin*

The increase in GraceDavison’s 2006 pretax operating income compared with 2005, was attributable tohigher volume of industrial-use materials, particularly in Europe, lower operatingexpenses and a better product mix. We report 100% of sales for the AdvancedRefining Technologies LLC joint venture, but only account for 55% of the incomein our measure of operating performance.

***Six Months Ended June 30, 2006***
| ** **                                                 | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------------------|------------|
| **Net Sales by Region***(In millions)* | ** ** | **2006**                                          | ** ** | **2005** | ** ** | **$ Change  Fav (Unfav)** | ** ** | **% Change  Fav (Unfav)** | ** ** |
| North America                                              | ** ** | **$**                                             | **262.5**  |   | $ | 257.6 |   | $ | 4.9 |   | 1.9 | % |
| Europe                                                     | ** ** | **307.8**                                         |       | 280.4 |   | 27.4 |   | 9.8 | % |
| Asia Pacific                                               | ** ** | **139.9**                                         |       | 125.0 |   | 14.9 |   | 11.9 | % |
| Latin America                                              | ** ** | **26.5**                                          |       | 30.6 |   | (4.1 | ) | (13.4 | %) |
| **Total Grace Davison**                                    | ** ** | **$**                                             | **736.7**  |   | $ | 693.6 |   | $ | 43.1 |   | 6.2 | % |

 

*Sales*

Sales increases for thesix months ended June 30, 2006 reflected similar economic conditions and costfactors as those experienced in the three months ended June 30, 2006, with theexception of sales in North America. Sales in this region were negatively affected during the quarter endedMarch 31, 2006 by continued shutdowns of several petroleum refineries from lastyear’s hurricanes and for preventive maintenance at customer sites.

Sales increases werepartially offset by unfavorable currency translation, which lowered theincrease by 2.3 percentage points.

*Pre-tax Operating Income and Margin*

The increase in operatingincome for the six months ended June 30, 2006 was a result of similar economicconditions and cost factors as those experienced in the three months ended June30, 2006.

***Grace Performance Chemicals***

*** ***

***Three Months Ended June 30, 2006***
| ** **                                                 | ** ** | **Three Months Ended June 30,** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **Net Sales by Region***(In millions)* | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **$ Change  Fav (Unfav)** | ** ** | **% Change  Fav (Unfav)** | ** ** |
| North America                                              | ** ** | **$**                                               | **163.2**  |   | $ | 153.3 |   | $ | 9.9 |   | 6.5 | % |
| Europe                                                     | ** ** | **115.6**                                           |       | 101.7 |   | 13.9 |   | 13.7 | % |
| Asia Pacific                                               | ** ** | **46.6**                                            |       | 42.9 |   | 3.7 |   | 8.6 | % |
| Latin America                                              | ** ** | **23.4**                                            |       | 19.7 |   | 3.7 |   | 18.8 | % |
| **Total Grace Performance  Chemicals**                     | ** ** | **$**                                               | **348.8**  |   | $ | 317.6 |   | $ | 31.2 |   | 9.8 | % |

 

*Sales*

The key factorscontributing to the increase in sales from our Grace Performance Chemicalsoperating segment were:

·                  Strongcommercial construction activity in the United States, which more than offset softnessin new residential construction;

·                  Improvedconstruction activity and product acceptance in Europe; and

·                  Higherselling prices in response to increases in raw material costs.

Sales growth was strongin all regions, reflecting geographic expansion and other growth initiatives.

*Pre-taxOperating Income and Margin*

The increase inGrace Performance Chemicals’ 2006 operating income compared with 2005, wasprimarily a result of sales volume growth in all geographic regions and sellingprice increases, partially offset by raw material cost inflation.

***Six Months Ended June 30, 2006***
| ** **                                                 | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------------------|------------|
| **Net Sales by Region***(In millions)* | ** ** | **2006**                                          | ** ** | **2005** | ** ** | **$ Change   Fav (Unfav)** | ** ** | **% Change   Fav (Unfav)** | ** ** |
| North America                                              | ** ** | **$**                                             | **310.4**  |   | $ | 283.5 |   | $ | 26.9 |   | 9.5 | % |
| Europe                                                     | ** ** | **208.2**                                         |       | 185.5 |   | 22.7 |   | 12.2 | % |
| Asia Pacific                                               | ** ** | **86.8**                                          |       | 80.7 |   | 6.1 |   | 7.6 | % |
| Latin America                                              | ** ** | **45.6**                                          |       | 36.4 |   | 9.2 |   | 25.3 | % |
| **Total Grace Performance  Chemicals**                     | ** ** | **$**                                             | **651.0**  |   | $ | 586.1 |   | $ | 64.9 |   | 11.1 | % |

 

*Sales*

Sales increases for thesix months ended June 30, 2006 reflected similar economic conditions and costfactors as those experienced in the three months ended June 30, 2006.

*Pre-tax Operating Income and Margin*

The increase in operatingincome for the six months ended June 30, 2006 was a result of similar economicconditions and cost factors as those experienced in the three months ended June30, 2006.

I-38

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***Operating Returns on Assets Employed***—****The following tables setforth the Grace Davison and Grace Performance Chemicals total asset positionand pre-tax return on average total assets as of June 30, 2006 and December 31,2005.  We use the measure pre-tax returnon average total assets as an indicator of our efficiency in using our assetsand allocating our resources to generate earnings.  We devote significantly higher capital to themanufacture of Grace Davison products than to the manufacture of GracePerformance Chemicals products. Conversely, nonmanufacturing costs,particularly selling expenses, are significantly higher for Grace PerformanceChemicals than for Grace Davison.
| **Grace Davison***(In millions)* | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Trade  receivables                         | ** ** | **$**                   | **205.1**  |                        | $          | 178.2 |   |
| Inventory                                  | ** ** | **214.1**               |       | 177.6                       |       |
| Other current  assets                      | ** ** | **18.2**                |       | 24.3                        |       |
| Total current  assets                      | ** ** | **437.4**               |       | 380.1                       |       |
| Properties and  equipment, net             | ** ** | **388.2**               |       | 390.7                       |       |
| Goodwill and  other intangible assets      | ** ** | **113.3**               |       | 98.2                        |       |
| Other assets                               | ** ** | **—**              |       | —                      |       |
| Total assets                               | ** ** | **$**                   | **938.9**  |                        | $          | 869.0 |   |
| Pre-tax return on  average total assets    | ** ** | **17.8**                | **%**      | 17.9                        | %          |

 

Grace Davison’stotal assets increased by $69.9 million in the first six months of 2006. Theincrease primarily was due to higher trade receivables caused by increasedsales, and higher inventory in response to sales growth and seasonality.
| **Grace Performance Chemicals***(In millions)* | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Trade receivables                                             | ** ** | **$**                   | **266.7**  |                        | $          | 222.7 |   |
| Inventory                                                     | ** ** | **95.2**                |       | 100.7                       |       |
| Other current  assets                                         | ** ** | **13.4**                |       | 15.7                        |       |
| Total current  assets                                         | ** ** | **375.3**               |       | 339.1                       |       |
| Properties and  equipment, net                                | ** ** | **236.0**               |       | 226.4                       |       |
| Goodwill and  other intangible assets                         | ** ** | **91.1**                |       | 93.5                        |       |
| Other assets                                                  | ** ** | **6.6**                 |       | 6.6                         |       |
| Total assets                                                  | ** ** | **$**                   | **709.0**  |                        | $          | 665.6 |   |
| Pre-tax return on  average total assets                       | ** ** | **24.2**                | **%**      | 22.4                        | %          |

 

Grace PerformanceChemicals’ total assets increased by $43.4 million in the first six months of2006, mainly due to higher trade receivables as a result of increased sales.

**Noncore Liabilities**

We have a number offinancial exposures originating from past businesses, products and events.These obligations arose from transactions and/or business practices that dateto when Grace was a much larger company, when we produced products or operatedbusinesses that are no longer part of our revenue base, and when governmentregulation was less stringent and scientific knowledge with respect to suchbusinesses and products was much less advanced than today.

The followingtable summarizes our net noncore liabilities at June 30, 2006 and December 31,2005:
| **Net Noncore Liabilities***(In millions)* | ** ** | **June 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                                | ** ** | **(368.6**              | **)**        | (342.0                      | )          |
| Postretirement  benefits                                  | ** ** | **(92.0**               | **)**        | (101.3                      | )          |
| Income taxes                                              | ** ** | **(134.4**              | **)**        | (136.5                      | )          |
| Retained  obligations and other                           | ** ** | **(22.2**               | **)**        | (23.4                       | )          |
| **Net noncore liability**                                 | ** ** | **$**                   | **(1,817.2** | **)**                       | $          | (1,803.2 | ) |

 

The resolution ofmost of these 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 beresolved. The amounts of these liabilities as ultimately determined through theChapter 11 proceedings could be materially different from amounts recorded atJune 30, 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.

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**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.  See Note 2 to the Consolidated FinancialStatements for more information on the plan of reorganization.**

***Risks of the plan of reorganization*** — We intend to address all pending and future asbestos-related claimsand all 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 Graceshareholders could be substantially diluted or cancelled. The value of Gracecommon stock following a plan of reorganization, and the extent of any recoveryby non-asbestos-related creditors, will depend principally on the allowed valueof our 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 (currently being considered by theU.S. Congress) for the personal injury component of this 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 may not satisfy the conditions precedent under thelitigation settlement agreements with Sealed Air and Fresenius and, therefore,may reduce or eliminate the availability of those assets to fund a plan ofreorganization.

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 bycurrent Grace shareholders beyond that reflected in the proforma financialinformation presented below. We will adjust our financial statements and theproforma effects of the plan of reorganization as facts and circumstanceswarrant.

***Proforma Financial Information*** — Theunaudited proforma financial information presented below reflects theaccounting effects of our proposed plan of reorganization (1) as if it were putin effect on the date of our most recent consolidated balance sheet — June 30,2006, and (2) as if it were in effect for (a) the full year ended December 31,2005, and (b) the six months ended June 30, 2006. 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:

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A.                 Borrowings UnderNew Debt Agreements and Contingencies

The plan of reorganization reflects the assumedestablishment of a new $1,000 million debt facility 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.  Proforma expensesreflect an assumed 7% interest rate on outstanding borrowings. No such facilitycurrently exists but, we expect, based on our discussions with prospectivelenders, that we can obtain a facility before the effective date of the plan ofreorganization. In addition, the proforma financial information reflects $150.0million in contingencies to pay professional and bank fees, other non-operatingliabilities and their related tax effects that will not become liabilitiesuntil the effective date of the plan of reorganization.

B.    Fresenius and Sealed AirSettlements

The plan ofreorganization reflects the value, in the form of cash and securities, expectedto be realized under litigation settlement agreements as follows: $115.0million of cash from Fresenius; and, $1,087.7 million of estimated value fromCryovac, Inc., a subsidiary of Sealed Air (calculated as of June 30, 2006) inthe form of $512.5 million of cash plus accrued interest at 5.5% from December21, 2002 compounded annually (approximately $106.5 million), and nine millionshares of Sealed Air common stock valued at $52.08 per share (approximately$468.7 million). Tax accounts have been adjusted to reflect the satisfaction ofour recorded liabilities by way of these third-party agreements. The Freseniussettlement amount will be payable directly to Grace and will be accounted foras income. Payments under the Sealed Air settlement will be paid directly tothe asbestos trust by Cryovac and will be accounted for as satisfaction of aportion of our recorded asbestos-related liability and a credit to shareholder’sequity. In addition, the valuation allowance related to our federal deferredtax assets will not be required as a result of these settlements and has thereforebeen reversed. Both the Sealed Air and Fresenius settlements are subject to thefulfillment of specified conditions.

C.      Payment of Pre-Petition Liabilities

The plan of reorganization reflects the transfer offunds and securities to settle estimated obligations payable under the plan ofreorganization at the effective date. We have adjusted tax accounts to reflectthe change in nature of our tax assets from predominately temporary differencesto predominately time-limited tax net operating losses. We have assumednon-asbestos pass-through liabilities will be paid in cash when due.

D.                  Proforma Consolidated Statement of Operations andCapital Structure

The proforma income adjustments reflect theelimination from our June 30, 2006 and December 31, 2005 ConsolidatedStatements of Operations of:

·                  Charges and expenses directly related toChapter 11;

·                  Other expenses and income related tomatters expected to be resolved before emerging from Chapter 11;

·                  The accounting for estimates andprovisions directly related to the plan of reorganization; and

·                  The addition of interest and new sharesof Grace common stock related to the assumed financing of the plan ofreorganization.

For purposes of proforma earnings per share andproforma share capital, we used the trading price of $11.70 per share as ofJune 30, 2006 for calculating issued and outstanding shares. At this per sharevaluation, we assume that 48.3 million shares will be issued at the effectivedate of the plan of reorganization to fund asbestos and general unsecuredclaims, 11.1 million shares would be issuable upon exercise of warrants tosatisfy our estimate of PI-AO claims, and 0.6 million shares would be issuedupon exercise of in-the-money stock options. We present the trading valuesolely to show proforma Consolidated Statements of Operations. This tradingvalue may not be indicative of the actual trading value of Grace common stockfollowing 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 $7.80 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 June 30, 2006 was between $6.75 and $17.49 per share.) These proformafinancial statements reflect no change in assets or income related to thispotential accounting outcome.

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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 of June30, 2006.  Certain liabilities areassumed to be paid at the effective date based on our estimate of amounts thatwill be determinable and payable. The remainder, which would also be subject tothe plan of reorganization, if approved, is assumed to be paid subsequent tothe effective date as amounts are either not due until a later date or will bedetermined through post-effective-date litigation. The ultimate value of suchclaims may change materially as Chapter 11 and other legal proceedings furtherdefine our non-asbestos related obligations.

 

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

** **
| ** **                                                                      | ** ** | ** **                                | ** ** | **Proforma Adjustments**                                                          | ** ** | ** **                                   | ** ** |
|---------------------------------------------------------------------------------|------------|-------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                      | ** ** | **June 30,  2006  As Reported** | ** ** | **Borrowings  Under New   Debt   Agreements  and   Contingencies** | ** ** | **Sealed Air/  Fresenius  Settlements** | ** ** | **Payment of  Pre-Petition  Liabilities** | ** ** | **June 30,  2006  Proforma** | ** ** |
| **ASSETS**                                                                      |       |                                      |       |                                                                                   |       |                                         |       |   |   |   |   |
| **Current Assets**                                                              |       |                                      |       |                                                                                   |       |                                         |       |   |   |   |   |
| Cash and cash  equivalents                                                      |       | $                                         | 443.2      |                                                                                   | $          | 800.0                                        |       | $ | 115.0 |   | $ | (1,042.5 | ) | $ | 315.7 |   |
| Other current  assets                                                           |       | 862.6                                     |       | —                                                                                 |       | —                                       |       | — |   | 862.6 |   |
| **Total Current Assets**                                                        |       | 1,305.8                                   |       | 800.0                                                                                  |       | 115.0                                        |       | (1,042.5 | ) | 1,178.3 |   |
| Non-current  operating assets                                                   |       | 992.9                                     |       | —                                                                                 |       | —                                       |       | — |   | 992.9 |   |
| Cash value of  life insurance                                                   |       | 86.6                                      |       | —                                                                                 |       | —                                       |       | — |   | 86.6 |   |
| Deferred income taxes:                                                          |       |                                      |       |                                                                                   |       |                                         |       |   |   |   |   |
| Net operating loss carryforwards                                                |       | 39.4                                      |       | —                                                                                 |       | (40.3                                        | )          | 123.6 |   | 122.7 |   |
| Temporary differences, net of valuation allowance                               |       | 687.0                                     |       | 26.3                                                                                   |       | (332.7                                       | )          | (123.6 | ) | 257.0 |   |
| Asbestos-related  insurance                                                     |       | 500.0                                     |       | —                                                                                 |       | —                                       |       | — |   | 500.0 |   |
| **Total Assets**                                                                |       | $                                         | 3,611.7    |                                                                                   | $          | 826.3                                        |       | $ | (258.0 | ) | $ | (1,042.5 | ) | $ | 3,137.5 |   |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY (DEFICIT)**                        |       |                                      |       |                                                                                   |       |                                         |       |   |   |   |   |
| Total current  liabilities                                                      |       | $                                         | 376.4      |                                                                                   | $          | —                                       |       | $ | — |   | $ | — |   | $ | 376.4 |   |
| Long-term debt                                                                  |       | 0.4                                       |       | 800.0                                                                                  |       | —                                       |       | — |   | 800.4 |   |
| Other noncurrent  liabilities                                                   |       | 599.7                                     |       | —                                                                                 |       | —                                       |       | — |   | 599.7 |   |
| **Total  Liabilities Not Subject to Compromise**                                |       | 976.5                                     |       | 800.0                                                                                  |       | —                                       |       | — |   | 1,776.5 |   |
| ** **                                                                      |       |                                      |       |                                                                                   |       |                                         |       |   |   |   |   |
| Bank  debt/letters of credit/capital leases                                     |       | 710.3                                     |       | —                                                                                 |       | —                                       |       | (708.8 | ) | 1.5 |   |
| Liability for  asbestos-related litigation and claims                           |       | 1,700.0                                   |       | —                                                                                 |       | (1,087.7                                     | )          | (482.3 | ) | 130.0 |   |
| Liability for  environmental remediation                                        |       | 368.6                                     |       | —                                                                                 |       | —                                       |       | (251.8 | ) | 116.8 |   |
| Liability for postretirement  health and special  pensions                      |       | 180.2                                     |       | —                                                                                 |       | —                                       |       | (12.2 | ) | 168.0 |   |
| Liability for  accounts payable and litigation                                  |       | 112.1                                     |       | —                                                                                 |       | —                                       |       | (90.5 | ) | 21.6 |   |
| Liability for  tax claims and contingencies                                     |       | 134.4                                     |       | —                                                                                 |       | —                                       |       | (12.0 | ) | 122.4 |   |
| Other  nonoperating liabilities, including plan of reorganization contingencies |       | —                                    |       | 150.0                                                                                  |       | —                                       |       | (50.0 | ) | 100.0 |   |
| **Liabilities  Subject to Compromise**                                          |       | 3,205.6                                   |       | 150.0                                                                                  |       | (1,087.7                                     | )          | (1,607.6 | ) | 660.3 |   |
| **Total  Liabilities**                                                          |       | 4,182.1                                   |       | 950.0                                                                                  |       | (1,087.7                                     | )          | (1,607.6 | ) | 2,436.8 |   |
| **Shareholder’s Equity (Deficit)**                                         |       |                                      |       |                                                                                   |       |                                         |       |   |   |   |   |
| Share capital                                                                   |       | 424.0                                     |       | —                                                                                 |       | —                                       |       | 565.1 |   | 989.1 |   |
| Retained  earnings and other equity items                                       |       | (994.4                                    | )          | (123.7                                                                                 | )          | 829.7                                        |       | — |   | (288.4 | ) |
| **Total  Shareholders’ Equity (Deficit)**                                  |       | (570.4                                    | )          | (123.7                                                                                 | )          | 829.7                                        |       | 565.1 |   | 700.7 |   |
| **Total Liabilities and  Shareholders’ Equity (Deficit)**                  |       | $                                         | 3,611.7    |                                                                                   | $          | 826.3                                        |       | $ | (258.0 | ) | $ | (1,042.5 | ) | $ | 3,137.5 |   |

 

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

 

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**W. R. Grace &Co. and Subsidiaries Proforma Consolidated Statements of Operations***(**Inmillions, except per share amounts)*
| ** **                                                                                                                                | ** ** | **Year Ended December 31, 2005** | ** ** | **Six Month Period Ended June 30, 2006** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                                                                                                | ** ** | **As  Reported**                                     | ** ** | **Proforma  Adjustments**                                              | ** ** | **Proforma** | ** ** | **As  Reported** | ** ** | **Proforma  Adjustments** | ** ** | **Proforma** | ** ** |
| **Net  Sales**                                                                                                                            |       | $                                                    | 2,569.5    |                                                                   | $          | — |   | $ | 2,569.5 |   | $ | 1,387.7 |   | $ | — |   | $ | 1,387.7 |   |
|                                                                                                                                      |       |                                                 |       |                                                                   |       |   |   |   |   |   |   |   |   |
| Cost of goods  sold, exclusive of depreciation and amortization shown separately below                                                    |       | 1,689.8                                              |       | —                                                                 |       | 1,689.8 |   | 908.2 |   | — |   | 908.2 |   |
| Selling, general  and administrative expenses, exclusive of net pension expense and  depreciation and amortization shown separately below |       | 481.1                                                |       | (39.4                                                                  | )          | 441.7 |   | 269.7 |   | (39.2 | ) | 230.5 |   |
| Depreciation and  amortization                                                                                                            |       | 114.0                                                |       | —                                                                 |       | 114.0 |   | 56.5 |   | — |   | 56.5 |   |
| Research and  development expenses                                                                                                        |       | 59.2                                                 |       | —                                                                 |       | 59.2 |   | 30.6 |   | — |   | 30.6 |   |
| Net pension  expense                                                                                                                      |       | 71.9                                                 |       | —                                                                 |       | 71.9 |   | 31.6 |   | — |   | 31.6 |   |
| Interest expense  and related financing costs                                                                                             |       | 55.3                                                 |       | 1.6                                                                    |       | 56.9 |   | 35.7 |   | (7.2 | ) | 28.5 |   |
| Provision for  environmental remediation                                                                                                  |       | 25.0                                                 |       | (25.0                                                                  | )          | — |   | 30.0 |   | — |   | 30.0 |   |
| Other (income)  expense                                                                                                                   |       | (67.4                                                | )          | 44.5                                                                   |       | (22.9 | ) | (15.8 | ) | 6.9 |   | (8.9 | ) |
| **Total  costs and expenses**                                                                                                             |       | 2,428.9                                              |       | (18.3                                                                  | )          | 2,410.6 |   | 1,346.5 |   | (39.5 | ) | 1,307.0 |   |
| **Income  (loss) before Chapter 11 expenses, income taxes, and minority interest**                                                        |       | 140.6                                                |       | 18.3                                                                   |       | 158.9 |   | 41.2 |   | 39.5 |   | 80.7 |   |
| Chapter 11  expenses, net                                                                                                                 |       | (30.9                                                | )          | 30.9                                                                   |       | — |   | (20.2 | ) | 20.2 |   | — |   |
| Benefit from  (provision for) income taxes                                                                                                |       | (21.3                                                | )          | (26.9                                                                  | )          | (48.2 | ) | (7.8 | ) | (14.0 | ) | (21.8 | ) |
| Minority  interest in consolidated entities                                                                                               |       | (21.1                                                | )          | —                                                                 |       | (21.1 | ) | (18.3 | ) | — |   | (18.3 | ) |
| **Net  income (loss)**                                                                                                                    |       | $                                                    | 67.3       |                                                                   | $          | 22.3 |   | $ | 89.6 |   | $ | (5.1 | ) | $ | 45.7 |   | $ | 40.6 |   |
| **Basic  earnings (loss) per share**                                                                                                      |       | $                                                    | 1.01       |                                                                   | —     |   | $ | 0.77 |   | $ | (0.08 | ) | — |   | $ | 0.35 |   |
| Weighted average  number of basic shares                                                                                                  |       | 66.8                                                 |       | 48.9                                                                   |       | 115.7 |   | 67.5 |   | 48.9 |   | 116.4 |   |
| **Diluted  earnings (loss) per share**                                                                                                    |       | $                                                    | 1.00       |                                                                   | —     |   | $ | 0.70 |   | $ | (0.08 | ) | — |   | $ | 0.32 |   |
| Weighted average number  of diluted shares                                                                                                |       | 67.3                                                 |       | 60.0                                                                   |       | 127.3 |   | 67.5 |   | 60.0 |   | 127.5 |   |

 

**FinancialCondition**

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

***Environmental Matters***—****See Note 12 to theConsolidated Financial Statements.

***Defined BenefitPension Plans***—****Wesponsor defined benefit pension plans for 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 andfund government sponsored programs in other countries where we operate.  Certain of our sponsored plans areadvance-funded and others are pay-as-you-go. The advance-funded plans areadministered by trustees who direct the management of plan assets and arrangeto have obligations paid when due out of a trust. The most significantadvance-funded plans cover our salaried employees in the U.S. and U.K. andemployees covered by collective bargaining agreements at certain of our U.S.facilities.

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. Such 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 currentretirees or employees of our former businesses, making the payout patternskewed to the nearer term. Assets available to fund the ABO at December 31,2005 were approximately $645 million, or approximately $320 million less thanthe measured obligation.

Assets available at June30, 2006 to fund the ABO of the U.S. advance-funded defined benefit pensionplans totaled approximately $646 million up $1 million from December 31, 2005.It is our intention to satisfy our obligations under the pension plans and tocomply with all of the requirements of the Employee Retirement Income SecurityAct of 1974. On June 16, 2006, Grace obtained Bankruptcy Court approval to fundminimum required payments of approximately $106 million for the period fromJuly 2006 through January 2007.  In thatregard, Grace contributed approximately $20 million in July 2006 to the truststhat hold assets of the Plans.  However,there can be no assurance that the Bankruptcy Court will continue to approvearrangements to satisfy the funding needs of the Plans. Contributions tonon-U.S. plans are not subject to bankruptcy court approval and we intend to fundsuch plans based on actuarial and trustee recommendations; $3.5 million and$6.8 million was funded during the three months and six months ended June 30,2006, respectively.

See Note 13 to theConsolidated Financial Statements for the components of net periodic benefitcost for each of the three-month and six-month periods ended June 30, 2006 and2005.  We expect total pension expensefor 2006 to be approximately $63 million, and benefit payments to retirees toaggregate to approximately $96 million for all pension programs in 2006.  At June 30, 2006, our recorded pensionliability for U.S. and non-U.S. underfunded plans was $533.7 million ($445.5million included in liabilities not subject to compromise and $88.2 millionrelated to supplemental pension benefits, included in “liabilities subject tocompromise”) which includes the following components: (1) shortfall betweendedicated assets and ABO of underfunded plans ($310.3 million); and (2) ABO ofpay-as-you-go plans ($223.4 million).

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***Postretirement Benefits Other Than Pensions***—****We provide certain health care and life insurance benefits forretired employees, a large majority of whom are retirees of divestedbusinesses. These plans are unfunded, and we pay the costs of benefits underthese plans as they are incurred. Our share of benefits under this program was$4.3 million and $6.5 million during the three months and six months ended June30, 2006, compared with $2.8 million and $5.1 million during the three monthsand six months ended June 30, 2005. Our recorded liability for postretirementbenefits of $92.0 million at June 30, 2006 is stated at net present valuediscounted at 5.5% (as discussed under Defined Benefit Pension Plans). Ourproposed plan of reorganization provides for the continuation of thesebenefits.

**Liquidity and Capital Resources**

***Cash Resources and AvailableCredit Facilities***—****At June 30, 2006, we had $443.2 million in cashand cash equivalents and $86.6 million in net cash value of life insurance. Inaddition, we had access to committed credit facilities in the U.S., Germany andFrance.  In the U.S., under the $250.0million DIP facility, $199.4 million was available at June 30, 2006 net ofletters of credit and holdback provisions. The term of the DIP facilityexpires April 1, 2008. In Germany, under a €10.0 million line of credit, we hadaccess to €5.3 million at June 30, 2006 net of bankers guarantees and otherholdbacks. The term of the facility expires January 17, 2007.  In France, under a €3.9 million line ofcredit, we had access to €3.2 million at June 30, 2006 net of bankersguarantees. The term of the facility expires June 30, 2007. We believe that these funds and credit facilitieswill be sufficient to finance our business strategy while in Chapter 11.

***Debt and Other Contractual Obligations***—******Total debtoutstanding at June 30, 2006 was $713.9 million, including $196.3 million ofaccrued interest on pre-petition debt. As a result of the Chapter 11 filing, we are now in default on $514.0million of pre-petition debt, which, together with accrued interest thereon,has been included in “liabilities subject to compromise” in the accompanyingConsolidated Balance Sheet as of June 30, 2006. The automatic stay providedunder the bankruptcy code prevents our lenders from taking any action tocollect the principal amounts as well as related accrued interest. However, wewill continue to accrue and report interest on such debt during the Chapter 11proceedings unless further developments lead management to conclude that it isprobable 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 six months ended June 30, 2006was $11.1 million, compared with a negative $74.6 million for the prior yearperiod. The higher cash flow is attributable to improved operating results in2006 and the non-recurrence of $119.7 million paid to settle tax andenvironmental contingencies in 2005. Pre-tax income from core operations beforedepreciation and amortization was $175.0 million, 11.5% higher than in theprior year period, a result of the higher income from core operations describedabove. Cash used for investing activities was $64.8 million, compared with$20.2 million for the prior year period, primarily reflecting capitalreplacements and investments in new production capacity, and the acquisition ofa custom catalyst business in June 2006.

***Cash Flow From Core Operations***—****The following table presents the components of net cash flow from core operations for the sixmonths ended June 30, 2006 and 2005.

 
| **Core Operations ***(In millions)*       | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                               | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| **Cash flows:**                                          | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Pre-tax  operating income                                | ** ** | **$**                                             | **118.5**  |   | $ | 96.3 |   |
| Depreciation and  amortization                           | ** ** | **56.5**                                          |       | 60.7 |   |
| **Pre-tax  income before depreciation and amortization** | ** ** | **175.0**                                         |       | 157.0 |   |
| Working capital  and other changes                       | ** ** | **(98.7**                                         | **)**      | (91.8 | ) |
| **Cash  flow before investing**                          | ** ** | **76.3**                                          |       | 65.2 |   |
| Capital  expenditures                                    | ** ** | **(51.9**                                         | **)**      | (36.8 | ) |
| Businesses  acquired                                     | ** ** | **(20.0**                                         | **)**      | (2.5 | ) |
| **Net cash flow from core  operations**                  | ** ** | **$**                                             | **4.4**    |   | $ | 25.9 |   |

 

We expect tocontinue to invest excess cash flow and/or other available capital resources inour core business base. These investments are likely to be in the form ofadditional plant capacity, product line extensions and geographic marketexpansions, and/or acquisitions in existing product lines.  Investments that are outside the ordinarycourse of business may be subject to bankruptcy court approval and review by theChapter 11 creditor committees.

***Cash Flow From Noncore Activities***— The cash flow from our noncoreactivities can be volatile.******Expenditures are generally governed by bankruptcy court rulingsand receipts are generally nonrecurring. Much of the noncore spending in thepast three years has been under Chapter 11 first-day motions that allow us tofund postretirement benefits and required environmental remediation onGrace-owned sites. Cash inflows have been from asbestos-related insurancerecovery on pre-Chapter 11 liability payments, and unusual events.

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| **Noncore Activities ***(In millions)* | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                            | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| **Cash flows:**                                       | ** ** | ** **                                        | ** ** | ** ** | ** ** |
| Pre-tax income  (loss) from noncore activities        | ** ** | **$**                                             | **(62.9**  | **)** | $ | 5.0 |   |
| Other non-cash  charges                               | ** ** | **41.4**                                          |       | 6.0 |   |
| Cash spending for:                                    |       |                                              |       |   |   |
| Noncore  contingencies:                               |       |                                              |       |   |   |
| Tax settlement                                        | ** ** | **—**                                        |       | (90.0 | ) |
| Environmental settlements                             | ** ** | **—**                                        |       | (29.7 | ) |
| Environmental remediation                             | ** ** | **(3.4**                                          | **)**      | (3.0 | ) |
| Postretirement benefits                               | ** ** | **(6.5**                                          | **)**      | (5.1 | ) |
| Retained obligations and other                        | ** ** | **(1.3**                                          | **)**      | (0.5 | ) |
| **Net cash flow from noncore  activities**            | ** ** | **$**                                             | **(32.7**  | **)** | $ | (117.3 | ) |

 

Net cash flow from coreoperations and net cash flow from noncore activities do not represent income orcash flow as defined under generally accepted accounting principles, and youshould not consider them to be an alternative to such measures as an indicatorof our performance. We provide these measures so that you can distinguish thecash flows of our current business base from the cash flows of past businesses,discontinued products, 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.
| **Reconciliation to Consolidated Statements of Cash Flows***(In millions)* | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                                    | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| Net cash flow  from core operations                                                                           | ** ** | **$**                                             | **4.4**    |   | $ | 25.9 |   |
| Net cash flow  from noncore activities                                                                        | ** ** | **(32.7**                                         | **)**      | (117.3 | ) |
| Cash paid for  interest, income taxes net of refunds, and Chapter 11 expenses                                 | ** ** | **(32.5**                                         | **)**      | (22.5 | ) |
| Investing  activities related to life insurance and sales of assets                                           | ** ** | **7.1**                                           |       | 19.1 |   |
| Financing  activities                                                                                         | ** ** | **15.3**                                          |       | 0.1 |   |
|                                                                                                          | ** ** | ** **                                        |       |   |   |
| Effect of  currency exchange rate changes on cash and cash equivalents                                        | ** ** | **6.9**                                           |       | (11.7 | ) |
| Increase (decrease) in  cash and cash equivalents per Consolidated Statements of Cash Flows                   | ** ** | **$**                                             | **(31.5**  | **)** | $ | (106.4 | ) |

 

See the “ConsolidatedStatements of Cash Flows” included in the Consolidated Financial Statements formore 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 DISCLOSURES ABOUTMARKET RISK**

Grace’s debtobligations, its global operations, the nature of the specialty chemicalsproduction process and the industry in which it engages expose Grace to variousmarket risks.  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 June 30, 2006, total interest accruedon this debt and added to the $500 million principal was $194.1 million.  If the Prime rate were to vary in thenear-term by one percentage point, the effect would be to increase or decreaseinterest expense and outstanding principal by approximately $14.5 million overthe twelve-month period ended June 30, 2007. Since the bank borrowings accrue interest at the Prime rate, Graceexpects that a hypothetical increase or decrease of one percentage point in thePrime rate would be unlikely to cause the fair market value of the debt tochange materially.  Grace’s bank debt is pre-Chapter 11debt that is thinly traded in private markets. Grace believes that the carryingamount of the debt, principal plus accrued interest, is consistent in allmaterial respects to the fair value of the bank borrowings as of June 30, 2006.

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 June 30, 2006, no amount was outstanding under this facility, and$199.4 million was available to Grace, net of letters of credit and holdbackprovisions.

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, or combinationsof the two to reduce the risk of certain specific transactions. However, Gracedoes not have a policy of hedging all exposures, because management does notbelieve that such a level of hedging would be cost-effective, particularlytranslation exposures that are not expected to affect cash flows in thenear-term.  Significant uses ofderivatives to mitigate the effects of changes in foreign currency exchangerates are as follows:

In May 2004, Gracepurchased forward contracts with a U.S. bank to minimize currency risk relatedto Euro-denominated intercompany loans due from a German subsidiary of Grace toa 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 these loans arerecorded as a component of operating results. The loans are denominated in Euros, and the total amount outstandingunder the intercompany loans was €171.4 million as of June 30, 2006(approximately $219.2 million).

Grace’s U.S.subsidiaries purchase a significant amount of products from Grace Canada, andthese purchases are denominated in Canadian dollars (CAD).  From time to time, Grace may purchase foreigncurrency exchange rate forward contracts in order to reduce the impact ofcurrency exchange to Grace’s consolidated gross margin as a result ofintercompany transactions denominated in CAD. As of June 30, 2006, Grace had not purchased foreign currency exchangerate forward contracts.

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The table belowprovides information about Grace’s significant foreign currency forwardexchange agreements as of June 30, 2006, specifically, the notional amounts andweighted average exchange rates by expected (contractual) maturity dates.  These notional amounts generally are used tocalculate the contractual payments to be exchanged under the contract. The fairvalues represent the fair value of the derivative contracts.

 
| **Forward Exchange Agreements (Receive $U.S./Pay Euros)** | ** ** | **Expected Maturity Date** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                             | ** ** | **2007** | ** ** | **2008** | ** ** | **Total** | ** ** | **Fair Value** | ** ** |
| Contract amount  (in millions of $U.S.)                                            |       | $                                    | 45.9       |   | $ | 92.8 |   | $ | 79.1 |   | $ | 217.8 |   | $ | (5.0 | ) |
| Average contractual  exchange rate, $U.S. to Euros                                 |       | 1.25                                 |       | 1.27 |   | 1.28 |   | 1.27 |   | N/A |   |
|                                                                                    |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

##### *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. hasalso formed a risk management committee to review proposals to hedge purchasesof 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 futures contracts, fixedprice swaps and options to hedge a portion of its 2006 and 2007 natural gasrequirements.   As of June 30, 2006,Grace has not entered into any commodity derivatives to hedge raw materialsprices.

The table belowprovides information about Grace’s futures 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.  For futures and options, the fair valuerepresents the excess of the market value amounts (as quoted on the New YorkMercantile Exchange) over the contract amount.

 
| **Type of Contract** | ** ** | **Contract   Volumes** | ** ** | **Maturity** | ** ** | **Weighted  Average   Price  ($US/MMBtu)** | ** ** | **Total   Contract Amount** | ** ** | **Fair   Value** | ** ** |
|--------------------------------|------------|-----------------------------|------------|--------------|------------|-------------------------------------------------|------------|---------------------------------------|------------|-----------------------|------------|
| Futures (long)                 |       | 250,000                     |       | 2006         |       | $                                               | 11.03      |                                  | $          | 2.8                   |       | $ | 2.0 |   |
| Swaps (long)                   |       | 300,000                     |       | 2007         |       | 8.15                                            |       | 2.4                                   |       | —                |       |
| Call Options (long)            |       | 350,000                     |       | 2006         |       | 10.09                                           |       | 3.5                                   |       | (0.4                  | )          |
|                                |            |                             |            |              |            |                                                 |            |                                       |            |                       |            |  |  |  |

 

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** **

**Item 4. CONTROLSAND PROCEDURES**

*EVALUATIONOF DISCLOSURE CONTROLS AND PROCEDURES*

As of June 30,2006, Grace carried out an evaluation of the effectiveness of the design andoperation 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 June 30, 2006 that have materially affected, or are reasonably likely tomaterially affect, Grace’s internal control over financial reporting.

 

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**PART II.  OTHER INFORMATION**

**Item 1.  LEGAL PROCEEDINGS**

**Notes 2, 3 and 12 to the interimconsolidated financial statements in Part I of this Report are incorporatedherein by reference.**

**Item 1A. RISKFACTORS**

With respect to certain risk factors disclosed in the “RiskFactors” section of our Annual Report on Form 10-K for the year ended December31, 2005, more recent numerical measures and other information are available inthe “Financial Statements,” “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” and “Quantitative and QualitativeDisclosures About Market Risk” sections of this Report.  These more recent measures and informationare incorporated herein by reference.

**Item 6.  EXHIBITS**

Exhibits.  The following is a list of Exhibits filed aspart of this 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: August 8, 2006 | By                                  | /s/ A. E. Festa |
|                 |                                | A. E. Festa |
|                 |                                | President and Chief Executive Officer |
|                 |                                |   |
|                 |                                |   |
| Date: August 8, 2006 | By                                  |  /s/ Robert M.  Tarola |
|                 |                                | Robert M. Tarola |
|                 |                                | Senior Vice President and Chief Financial Officer |
|                 |                                | (Principal Accounting Officer) |

 

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**EXHIBITINDEX**
| 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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