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**UNITEDSTATES********SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-K**

 

**x****      ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**For the fiscal year ended October 31, 2009.**

 

**Or**

 

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

 

**for the transition period from                       to                       .**

 

**CommissionFile Number  000-51825**

 

**HeronLake BioEnergy, LLC**

(Exact name ofregistrant as specified in its charter)

 

| **Minnesota**                                                   | ** ** | **41-2002393**                     |
|-----------------------------------------------------------------|------------|------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |       | (IRS Employer  Identification No.) |

 

**91246390****th****Avenue,Heron Lake, MN 56137-1375**

(Address ofprincipal executive offices)

 

Registrant’stelephone number, including area code:  **(507)793-0077**

 
| **Securities registered pursuant to Section 12(b) of the Act:** | ** ** | **Securities registered pursuant to Section 12(g) of the Act:** |
|---------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|
| **Class A Units**                                                    | ** ** | **None**                                                                  |

 

Name of Exchange on WhichRegistered: **None**

 

Indicate by check markwhether the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act: Yes o   No x

 

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act: Yes o No x

 

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

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T during the preceding 12months (or for such shorter period that the registrant was required to submitand post such files). Yes o   No o

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated by referencein Part III of this Form 10-K or any amendment to this Form 10-K.x

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer or anon-accelerated filer.

 

| Large  Accelerated Filer o |   | Accelerated  Filer o         |
|----------------------------|--------|------------------------------|
|                       |   |                         |
| Non-Accelerated  Filer o   |   | Smaller  Reporting Company x |

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 126-2 of theAct) Yes o   No x

 

The aggregate marketvalue of the Company’s Class A Units held by non-affiliates is not able tobe calculated. The Company is a limited liability company whose outstandingcommon equity, consisting of its Class A Units, is subject to significantrestrictions on transfer under its Member Control Agreement. No public marketfor common equity of Heron Lake BioEnergy, LLC is established and it isunlikely in the foreseeable future that a public market for its common equitywill develop.

 

As of January 26,2010, the Company had outstanding 27,104,625 Class A Units.

 

**DOCUMENTS INCORPORATED BY REFERENCE:**

 

Portions of theregistrant’s definitive proxy statement for its 2010 Annual Meeting of Members,to be filed within 120 days after the end of the fiscal year covered by thisreport, are incorporated by reference into Part III hereof.

 

 

 

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| **PART I**   |                                                                                                                    |
|-------------------|-------------------------------------------------------------------------------------------------------------------------|
|              |                                                                                                                    |
| Item  1.          | Business                                                                                                                |
| Item  1A.         | Risk  Factors                                                                                                           |
| Item 1B.          | Unresolved  Staff Comments                                                                                              |
| Item  2.          | Properties                                                                                                              |
| Item 3.           | Legal Proceedings                                                                                                       |
| Item 4.           | Submission  of Matters to a Vote of Security Holders                                                                    |
|              |                                                                                                                    |
| **PART II**  |                                                                                                                    |
|              |                                                                                                                    |
| Item 5.           | Market for  the Registrant’s Common Equity, Related Stockholder Matters and Issuer  Purchases of Equity Securities |
| Item 6.           | Selected Financial  Data                                                                                                |
| Item 7.           | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                             |
| Item 7A.          | Quantitative  and Qualitative Disclosures about Market Risk                                                             |
| Item 8.           | Financial  Statements and Supplementary Data                                                                            |
| Item 9.           | Changes in  and Disagreements with Accountants on Accounting and Financial Disclosure                                   |
| Item 9A.          | Controls  and Procedures                                                                                                |
| Item 9B.          | Other  Information                                                                                                      |
|              |                                                                                                                    |
| **PART III** |                                                                                                                    |
|              |                                                                                                                    |
| Item 10.          | Directors,  Executive Officers and Corporate Governance                                                                 |
| Item 11.          | Executive  Compensation                                                                                                 |
| Item 12.          | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                        |
| Item 13.          | Certain  Relationships and Related Transactions, and Director Independence                                              |
| Item 14.          | Principal  Accountant Fees and Services                                                                                 |
|              |                                                                                                                    |
| **PART IV**  |                                                                                                                    |
|              |                                                                                                                    |
| Item 15.          | Exhibits and  Financial Statement Schedules                                                                             |
|              |                                                                                                                    |
| **SIGNATURES**    |

 

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**PART I**

 

When we use the terms “HeronLake BioEnergy,” “we,” “us,” “our,” the “Company”, “HLBE” or similar words inthis Annual Report on Form 10-K, unless the context otherwise requires, weare referring to Heron Lake BioEnergy, LLC and its subsidiary, LakefieldFarmers Elevator, LLC with grain facilities at Lakefield and Wilder,Minnesota.  Additionally, when we referto “units” in this Annual Report on Form 10-K, unless the contextotherwise requires, we are referring to the Class A units of Heron LakeBioEnergy, LLC.

 

**Forward-LookingStatements**

 

**CAUTIONARYSTATEMENTS REGARDING FORWARD-LOOKING STATEMENTS**

 

This annual reportcontains historical information, as well as forward-looking statements thatinvolve known and unknown risks and relate to future events, our futurefinancial performance, or our expected future operations and actions.  Insome cases, you can identify forward-looking statements by terminology such as “may,”“will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “future,”“intend,” “could,” “hope,” “predict,” “target,” “potential,” or “continue” orthe negative of these terms or other similar expressions.  Theseforward-looking statements are only our predictions based on currentinformation and involve numerous assumptions, risks and uncertainties. Our actual results or actions may differ materially from these forward-lookingstatements for many reasons, including the reasons described in this reportunder Part I, Item 1A. “Risk Factors” of this Form 10-K.

 

We undertake no duty toupdate these forward-looking statements, even though our situation may changein the future. We caution you not to put undue reliance on any forward-lookingstatements, which speak only as of the date of this report.

 

**ITEM1.          BUSINESS**

 

**Overview**

 

We were organized as aMinnesota limited liability company on April 12, 2001 under the name “GenerationII, LLC.”  In June 2004, we changed our name to Heron Lake BioEnergy,LLC.

 

We were formed for thepurpose of constructing and operating an ethanol manufacturing facility nearHeron Lake, Minnesota. On September 21, 2007, we began operations at ourdry mill, coal fired ethanol plant. Fiscal year 2007 was the first fiscal yearthat includes any revenue generated from our operations. In our fiscal year2009 which ended October 31, 2009, we sold approximately 46.5 milliongallons of ethanol. At nameplate, the ethanol plant has the capacity to processapproximately 18.0 million bushels of corn each year, producing approximately50 million gallons per year (mgy) of fuel-grade ethanol and approximately160,000 tons of distillers’ grains with solubles (“DGS”).

 

The following table setsforth a summary of significant milestones in our company’s history until webegan operations at our plant.

 
| **Date**            | ** ** | **Milestone**                                                                                                                                                                                        |
|---------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                 |
| February 2002  |       | We obtained an option on land that is now part of  the 216 acre site of our ethanol plant.                                                                                                           |
| October 2003   |       | We entered into an industrial water supply  development and distribution agreement with the City of Heron Lake, Jackson  County, and Minnesota Soybean Processors.                                   |
| Early 2004          |       | We selected Fagen, Inc. to be the design-build  firm to build our ethanol plant near Heron Lake, Minnesota, using process  technology provided by ICM, Inc.                                |
| September 2005 |       | We entered into a Standard Form of Agreement  between Owner and Designer — Lump Sum with Fagen, Inc.                                                                                  |
| December 2005  |       | We purchased certain assets relating to elevator and  grain storage facilities in Lakefield, Minnesota and Wilder, Minnesota with a  combined storage capacity of approximately 2.8 million bushels. |
| May 2006       |       | We entered into an industrial water supply treatment  agreement with the City of Heron Lake and Jackson County.                                                                                      |
| August 2006    |       | We entered into an electric service agreement with  Interstate Power and Light Company (a wholly-owned subsidiary of Alliant  Energy Corporation).                                                   |
| December 2006  |       | We entered into a contract with Federated Rural  Electric Association for the construction of the distribution system and  electrical substation for the plant.                                      |
| June 2007      |       | We entered into a master coal supply agreement with  Northern Coal Transportation Company (NCTC) to provide Powder River Basin  (PRB) coal for the plant.                                            |
| June 2007      |       | We entered into a coal transloading agreement with  Southern Minnesota Beet Sugar Cooperative (SMBSC).                                                                                               |
| September 2007 |       | We began operations at our dry mill, coal fired  ethanol plant.                                                                                                                                      |

 

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**Production**

 

Since the beginning ofoperations at our ethanol plant, our primary business is the production andsale of ethanol and co-products, including dried distillers’ grains. Wecurrently do not have or anticipate we will have any other lines of business orother significant sources of revenue other than the sale of ethanol and ethanolco-products.

 

**Our Ethanol Plant**

 

Our ethanol plant wasdesigned and built by Fagen Inc. under a September 2005 design-buildagreement. Under the design-build agreement, Fagen, Inc. also agreed toutilize certain proprietary property and information of ICM, Inc. in thedesign and construction of our ethanol plant.

 

Our ethanol plant uses adry milling process to produce fuel-grade ethanol and distillers’ grains. Thedry milling process involves grinding the entire corn kernel into flour and thestarch is converted to ethanol through fermentation that also produces carbondioxide and distillers’ grains.

 

The ethanol plant consistsprincipally of a coal handling, storage and combustion area; storage andprocessing areas for corn; a fermentation area comprised mainly of fermentationtanks; a distillation finished product storage area; and a drying unit forprocessing the dried distillers’ grains. Additionally, the ethanol plantcontains receiving facilities that have the ability to receive corn by rail andtruck, store it for use in the plant and prepare the corn to be used in theplant. We have storage tanks on site to store the ethanol we produce. The plantalso contains a storage building and silos to hold distillers’ grains until itis shipped to market.

 

The Union PacificRailroad is the railroad adjacent to our ethanol plant.  The ethanol planthas the facilities necessary to receive corn by truck and rail, coal by truck,and to load ethanol and distillers grains onto trucks and rail cars.

 

As part of ourdesign-build agreement with Fagen, Inc., we received performanceguarantees on the production through put and process efficiencies of ourethanol plant. Fagen, Inc. has also warranted that the air emissions onour ethanol facility, taken as a whole, when operating at nameplate capacitymeeting all of the performance guarantee criteria, will meet the requirementsof a synthetic minor source within six months following the date of substantialcompletion. If this warranty is not met, Fagen, Inc. will pay all design,engineering, equipment, labor and construction costs associated with making thenecessary corrections to meet the warranty, subject to certainrestrictions.  Notwithstanding that we began operations on September 21,2007, our plant does not yet meet the warranties relating to air emissions.

 

We have made payments toFagen, Inc. as required under the design-build agreement and as providedin the design-build agreement.  We retained 10% of each payment until 50%of the required work was completed by Fagen, Inc.  As of October 31,2009, we have retained approximately $3.8 million in payments to Fagen, Inc. We have been unsuccessful in resolving a dispute with Fagen, Inc, with regardto its liability for our claims under the design-build agreement.  On September 18, 2009, we commenced anarbitration action against Fagen, Inc. following these unsuccessfulattempts.  Our claims are for breach ofwarranty, breach of contract, and negligence, among other counts, and we areasking for total damages of approximately $22.8 million.  A revised demand for arbitration was servedand filed on December 23, 2009 following an unsuccessful attempt tomediate the dispute.  Fagen, Inc.responded to the demand for arbitration by denying liability and assertingvarious affirmative defenses.  Inaddition, Fagen, Inc. brought a counterclaim alleging that it is entitledto payment of the retainage we hold in the amount of approximately $3.8million.  In addition, Fagen, Inc.alleges that it performed additional work and provided additional labor andmaterials to the plant in the amount of approximately $2.2 million, which didnot constitute warranty or guarantee work and therefore, it claims it isentitled to payment of this additional amount. We responded to the counterclaim by denying the allegations andasserting various affirmative defenses.  On January 4,2010, Fagen, Inc. requested to join ICM, Inc. as a party to thearbitration action, claiming that joinder was necessary for proper resolutionof the claims and defenses in the arbitration action.  On January 27, 2010, ICM, Inc.responded to the request, agreeing to be joined provided certain procedures areestablished.  In its response, ICM alsoindicated that it intends to assert claims against us under the licenseagreement we entered into with ICM as part of the design build agreement withFagen.  On January 27, 2010, wefiled our response and objections to Fagen’s request to join ICM as a party,and requested that a special arbitrator be appointed to resolve the joinderissues.  We intend to defend against theFagen counterclaims and any claims brought by ICM, Inc. and assert ourdefenses vigorously.  Please see Part I, Item 3 “LegalProceedings” of this Form 10-K for a description of the arbitration actionagainst Fagen, Inc. relating to the design-build agreement.

 

Our ethanol plantrequires significant and uninterrupted amounts of electricity, coal and water.We have entered into agreements for our supply of electricity, coal and water.

 

Currently, fly-ashgenerated from the coal burned by our plant is hauled to a landfill. If itqualifies to predefined industry standards, fly-ash can be used as an admixturefor cement mixes instead of being hauled to landfills. We are continuing toexplore revenue-generating alternatives from fly-ash rather than incurringexpense associated with shipping the fly-ash to landfills.

 

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**Our Principal Products**

 

The principal productsthat we produce are fuel grade ethanol and distillers’ grains. Raw carbondioxide is also a product of the ethanol production process, but we do notcapture or market any carbon dioxide gas.

 

*Ethanol*

 

Ethanol is a type ofalcohol produced in the U.S. principally from corn. Ethanol is primarily usedin the U.S. gasoline fuel market as:

 

·                       an octane enhancer in fuels;

 

·                       an oxygenated fuel additive that canreduce ozone and carbon monoxide vehicle emissions;

 

·                       a gasoline substitute generally known asE85, a fuel blend composed of 85% ethanol; and

 

·                       as a renewable fuel to displaceconsumption of imported oil.

 

Ethanol used as an octaneenhancer or fuel additive is blended with unleaded gasoline and other fuelproducts. The principal purchasers of ethanol are generally wholesale gasolinedistributors or blenders.

 

*Distillers’ Grains*

 

The principal co-productof the ethanol production process is distillers’ grains, a high protein andhigh-energy animal feed ingredient.

 

Dry mill ethanolprocessing creates three primary forms of distillers’ grains: wet distillers’grains, modified wet distillers’ grains, and dried distillers’ grains withsolubles. Wet distillers’ grains are processed corn mash that contains asubstantial amount of moisture. It has a shelf life of approximately three daysand is primarily sold to feeders of beef animals within the immediate vicinityof the ethanol plant. Modified wet distillers’ grains are similar to wetdistillers’ grains except that it has been partially dried and contains lessmoisture. Modified wet distillers’ grains has a shelf life of a maximum offourteen days, contains less water to transport, is more easily adaptable tosome feeding systems, and is sold to both local and regional markets, primarilyfor both beef and dairy animals. Dried distillers’ grains with solubles arecorn mash that has been dried to approximately 10% moisture. It has an almostindefinite shelf life and may be sold and shipped to any market and to almostall types of livestock. Most of the distillers’ grains that we sell are in theform of dried distillers’ grains.

 

**Procurement and Marketing Agreements**

 

*Corn Procurement*

 

The primary raw materialused in the production of ethanol at our plant is corn. We need to procureapproximately 18 million bushels of corn per year for our dry mill ethanolprocess. We generally do not have long-term, fixed price contracts for thepurchase of corn and our members are not obligated to deliver corn to us.Typically, we purchase our corn directly from grain elevators, farmers, andlocal dealers within approximately 80 miles of Heron Lake, Minnesota.

 

We generally purchasecorn through cash fixed-price contracts and may utilize hedging positions inthe corn futures market for a portion of our corn requirements to manage therisk of excessive corn price fluctuations. Our fixed-price forward contractsspecify the amount of corn, the price and the time period over which the cornis to be delivered. These forward contracts are at fixed prices or prices basedon the Chicago Board of Trade (CBOT) prices. Our corn requirements can beforward contracted on either a fixed-price basis or futures only contracts. Theparameters of these contracts are based on the local supply and demandsituation and the seasonality of the price. We also purchase a portion of ourcorn on a spot basis.

 

The price andavailability of corn is subject to significant fluctuation depending upon anumber of factors that affect commodity prices generally. These include, amongothers, crop conditions, crop production, weather, government programs, andexport demands.  We believe that our cornstorage facilities in Lakefield and Wilder, Minnesota enable us to morefavorably procure corn for the operation of our plant.

 

*Coal Procurement*

 

We have constructed acoal receiving, handling and storage facility next to the ethanol plant. Due to air permitting, and performance and emissions guarantees of thedesign-build contract with Fagen, Inc., a Wyoming/Montana-sourced coalmust be used.  As a result, in June 2007,

 

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we entered into a master coal supply agreement withNorthern Coal Transportation Company (NCTC) to provide Powder River Basin (PRB)coal for the plant.  The master coal supply agreement expires upon 60 daysnotice by either party.  We are obligated to purchase coal and NCTC isobligated to sell coal identified in a confirmation that sets forth thequantity, price, term, mine and other relevant terms.  Under a letterconfirmation dated July 2007, we agreed to purchase a minimum number oftons in each contract year which runs from June 1 to May 31 throughthe five year period ending May 31, 2012.  The letter confirmationalso sets the price per ton for each contract year.  Also, in June 2007,we entered into a coal transloading agreement with Southern Minnesota BeetSugar Cooperative (SMBSC).  SMBSC also uses coal of the same type as ourethanol plant to fuel its beet sugar plant.  In order to achievetransportation efficiencies, we and SMBSC entered into the coal transloadingagreement so that both of our coal orders could be delivered to a singlefacility (the transloading facility) owned by SMBSC.  The coal istransferred from the transloading facility to each of our respective plants andwe pay SMBSC a per ton charge handling fee for the use of the transloadingfacility.

 

*Ethanol Marketing*

 

Effective September 30,2009, we entered into an ethanol marketing agreement with C&N EthanolMarketing Corporation (“C&N”).  Underthe Agreement, C&N will purchase, market and re-sell all of the ethanolproduced at the Company’s plant for the three year term of the Agreement. Following the three year term, the Agreement will automatically renew forsubsequent year terms unless either party terminates the agreement 60 daysbefore the end of the term.  C&N will provide the Company with aremittance by Wednesday of each week for shipments of ethanol in the previousweek and the Company will receive payment against that remittance on thefollowing Wednesday.  C&N will pay the Company the gross sales priceto the customer less expenses and a 1% marketing fee after expenses.  TheAgreement also contains provisions addressing other matters, includingforecasting, the quality of product, transfer of title and auditing of records.

 

The Company has notifiedRPMG, Inc. (“RPMG”) of the termination effective September 30, 2009of the Ethanol Fuel Marketing Agreement between the Company and RPMG, Inc.dated August 7, 2006 (the “Prior Agreement”). Under the Prior Agreement,RPMG marketed all ethanol produced by the Company’s ethanol plant pursuant to apooled marketing arrangement. The Company received a price equal to the actualpooled price received by RPMG, less the expense of distribution and a marketingfee charged per gallon of ethanol sold.

 

Ethanol revenues duringthe period ended October 31, 2009 were approximately $70.4 million,comprising 80% of our revenues. Sales of ethanol through September 30,2009 were made pursuant to the terms of our ethanol marketing agreement withRPMG, Inc. under which our ethanol was pooled with the ethanol of otherethanol producers whose ethanol was marketed by RPMG.  We paid RPMG amarketing fee and RPMG paid us a netback price per gallon that is based uponthe difference between the pooled average delivered ethanol selling price andthe pooled average distribution expense.  These averages werecalculated based upon each pool participant’s selling price and expenseaveraged in direct proportion to the volume of ethanol supplied by eachparticipant to the pool.

 

We believe that theethanol market structure has changed since we entered into our ethanolmarketing agreement with RPMG, and in particular during the past one to twoyears.  We determined, in light of those changes, that the poolmarketing arrangement used by RPMG was no longer an effective arrangement underthe current market structure and circumstances. We accordingly notified RPMGthat the ethanol marketing agreement would be terminated effective September 30,2009.

 

*Distillers’ Grains Marketing*

 

In addition to ethanol,our ethanol plant produces wet, modified wet and dried distillers’ grains.

 

In October 2005, weentered a marketing agreement with Commodity Specialists Corporation for thesale to Commodity Specialists Corporation of all distillers’ grains produced byour ethanol plant. The term of the agreement is for a one-year period from thedate of start-up of our operations, and thereafter, the agreement will remainin effect unless terminated by either party upon 90 days’ written notice. Underthe terms of the agreement, we receive a price equal to the selling price, lessa charge of 2% or 4% of the price for distillers’ grains and a fee of $2.00 perton of solubles, less the cost of delivering the product to the customer. In August 2007,as part of CHS Inc.’s acquisition of Commodity Specialist Corporation, ouragreement with Commodity Specialist Corporation was assigned to CHS Inc. withour consent.

 

*Pricing of Corn and Ethanol*

 

The sale of ethanolrepresented approximately 80% of our revenue for the year ended October 31,2009. The cost of corn represented approximately 70% of our cost of sales forthe year ended October 31, 2009. In the future, we expect that ethanolsales will represent our primary revenue source and corn will represent our primarycomponent of cost of goods sold. Therefore, changes in the price at which wecan sell the ethanol we produce and the price at which we buy corn for ourethanol plant present significant operational risks inherent in our business.

 

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Generally, the price atwhich ethanol can be sold does not track with the price at which corn can bebought. Historically, ethanol prices have tended to correlate with wholesalegasoline prices, with demand for and the price of ethanol increasing assupplies of petroleum decreased or appeared to be threatened, crude oil pricesincreased and wholesale gasoline prices increased. However, the prices of bothethanol and corn do not always follow historical trends. Trends in ethanolprices and corn prices are subject to a number of factors and are difficult topredict.

 

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**Demandfor Ethanol**

 

In recent years, thedemand for ethanol has increased, particularly in the upper Midwest, in partbecause of two major programs established by the Clean Air Act Amendments of1990:  the Oxygenated Gasoline Program and the Reformulated GasolineProgram.  Under these programs, an additive (oxygenate) was required to beadded to the gasoline used in areas with excessive carbon monoxide or ozonepollution to help mitigate these conditions. Because of the potential healthand environmental issues associated with methyl tertiary butyl ether (MTBE) andthe actions of the EPA, ethanol is now used as the primary oxygenate in thoseareas requiring an oxygenate additive under programs associated with the CleanAir Act Amendments of 1990 or other federal law.  According to the EPA, asof May 2007, various regions of 15 states and the District of Columbiawere required to comply with the Reformulated Gasoline Program and all or aportion of an additional 13 states have voluntarily opted into the program.

 

In addition to demand forethanol as an oxygenate, ethanol demand has increased because of the adoptionof programs setting national renewable fuels standards (RFS).  The first RFSprogram was introduced through the Energy Policy Act of 2005.  The EnergyPolicy Act of 2005 introduced a RFS program that set a national minimum usagerequirement that would phase in over seven years, beginning with approximately4.0 billion gallons in 2006 and increasing to 7.5 billion gallons by2012.  The minimum usage requirements under the 2005 RFS program wereincreased with the Energy Independence and Security Act of 2007. Currently, theminimum usage requirements are 13.2 billion gallons of renewable biofuels by2012 and 15.0 billion gallons by 2015.  The Energy Independence andSecurity Act of 2007 also mandates a minimum requirement of 36 billion gallonsof renewable fuels by 2022, with conventional biofuels accounting for 15billion gallons of this total.  Conventional biofuel is ethanol derivedfrom corn starch and conventional ethanol facilities that commence constructionafter the date of enactment and must achieve a 20 percent greenhouse gas (GHG)emissions reduction compared to baseline lifecycle GHG emissions. Advanced biofuels are defined as cellulosic ethanol and other biofuels derivedfrom feedstock other than corn starch that achieves a 50 percent GHG emissionsreduction requirement. Cellulosic ethanol is any cellulose, hemicellulose, orlignin that is derived from renewable biomass and achieves a 60 percent GHGemission reduction requirement.  We believe the RFS program createsgreater market for renewable fuels, such as ethanol, as a substitute forpetroleum-based fuels.

 

In addition to the RFSprogram, one important incentive for the ethanol industry and its customers isthe Volumetric Ethanol Excise Tax Credit, commonly referred to as the “blender’scredit.”  The tax credit is provided to gasoline distributors as anincentive to blend their gasoline with ethanol.  For each gallon ofgasoline blended with ethanol, the distributors receive a tax credit.  For2008, the tax credit is 51¢ per gallon of pure ethanol or 5.1¢ per gallon ofgasoline blended with 10% ethanol.  The per gallon credit was reduced to45¢ per gallon of pure ethanol in 2009.  The tax credit is authorizedthrough December 21, 2010.

 

In Minnesota, a market weserve, the demand for ethanol is driven, in part, by state specificrequirements. Minnesota has enacted a law that requires all Minnesota gasolineto be blended with 20 percent ethanol. The new E-20 mandate would take effectin 2013 unless ethanol has already replaced 20 percent of the state’s motorvehicle fuel by 2010. The rule would expire at the end of 2010 if Minnesotais not granted federal approval to use E-20 gasoline blends.  Minnesotahas North America’s largest network of E-85 (85% ethanol blend) gas stationswith approximately 350 stations now available to consumers. Minnesota was thefirst state to require the use of ethanol in gasoline.  Other states arebeginning to enact similar legislation and this may also drive the demand forethanol in markets we serve.

 

**Markets for Ethanol**

 

There are local, regionaland national markets for ethanol. Typically, a regional market is one that isoutside of the local market, yet within the neighboring states. Some regionalmarkets include large cities that are subject to anti-smog measures in eithercarbon monoxide or ozone non-attainment areas, or that have implementedoxygenated gasoline programs, such as Chicago, St. Louis, Denver andMinneapolis. We consider our primary regional market to be large cities withina 450-mile radius of our ethanol plant. In the national ethanol market, thehighest demand by volume is primarily in the southern United States and theeast and west coast regions.

 

The markets in which ourethanol is sold will depend primarily upon the efforts of C&N, which buysand markets our ethanol. However, we believe that local markets will be limitedand must typically be evaluated on a case-by-case basis. Although local marketswill be the easiest to service, they may be oversold because of the number ofethanol producers near our plant, which may depress the price of ethanol inthose markets.

 

We transport our ethanolprimarily by rail. In addition to rail, we service certain regional markets bytruck from time to time. We believe that regional pricing tends to follownational pricing less the freight difference.

 

We believe that the E10 “blendwall” is one of the most critical governmental policies currently facing theethanol industry.  The “blend wall” issue arises because of severalconflicting requirements.  First, the renewable fuels standardsdictate a continuing increase in the amount of ethanol blended into thenational gasoline supply.  Second, the Environmental ProtectionAgency (EPA) mandates a limit of 10% ethanol inclusion in non-flex fuelvehicles, and the E85 vehicle marketplace is struggling to grow due to lackinginfrastructure.  Total gasoline usage by

 

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the U.S. is currently around 138 billion gallons, andis expected to decrease to less than 130 billion gallons over the next 5 yearsas fuel mileage standards are changed.  The RFS dictates anincreasing amount of ethanol blending:  13.95 billion gallons in2011, 15.2 billion gallons in 2012, and increasing to 36 billion gallons by2022.  To reach the standard as dictated by the RFS in 2011, assuming135 billion gallons of total gasoline usage nationally, each gallon of gasolinesold would have to be blended with greater than 10% ethanol.  The EPApolicy of 10% and the RFS increasing blend rate are at odds, which is sometimesreferred to as the “blend wall.”  One industry group has petitionedthe EPA for a waiver of the E10 law and an increase to E15.  The EPAhas currently postponed the expected December 2009decision.  This issue is a major risk to the ethanol industry.

 

**Markets for Distillers’ Grains**

 

We sell distillers’grains as animal feed for beef and dairy cattle, poultry and hogs. However, themodified wet distillers’ grains typically have a shelf life of a maximum offourteen days. This provides for a much smaller market and makes the timing ofits sale critical. Further, because of its moisture content, the modified wetdistillers’ grains are heavier and more difficult to handle. The customer mustbe close enough to justify the additional handling and shipping costs. As aresult, modified wet distillers’ grains are principally sold only to localfeedlots and livestock operations.

 

Various factors affectthe price of distillers’ grain, including, among others, the price of corn,soybean meal and other alternative feed products, the performance or value ofdistillers’ grains in a particular feed market, and the supply and demandwithin the market. Like other commodities, the price of distillers’ grains canfluctuate significantly.

 

**Competition**

 

*Producers of Ethanol*

 

We sell our ethanol in ahighly competitive market. We are in direct competition with numerous otherethanol producers, both regionally and nationally, many of which have moreexperience and greater resources than we have. Some of these producers are,among other things, capable of producing a significantly greater amount ofethanol or have multiple ethanol plants that may help them achieve certainbenefits that we could not achieve with one ethanol plant. Further, newproducts or methods of ethanol production developed by larger andbetter-financed competitors could provide them competitive advantages over usand harm our business. A majority of the ethanol plants in the U.S. and thegreatest number of gallons of ethanol production are located in thecorn-producing states, such as Iowa, Nebraska, Illinois, Minnesota, SouthDakota, Indiana, Ohio, Kansas, and Wisconsin.

 

Below is the U.S. ethanolproduction by state in millions of gallons for the ten states with the mosttotal ethanol production, either online or under construction/expansion, as of January 2009:

 
| **State**       | ** ** | **Online** | ** ** | **Under Construction/  Expansion** | ** ** | **Total**  | ** ** |
|-----------------|------------|------------|------------|-----------------------------------------|------------|------------|------------|
| *Iowa*          | * *   | *3,076.0*  | * *   | *690.0*                                 | * *   | *3,766.00* | * *   |
| *Nebraska*      | * *   | *1,444.0*  | * *   | *319.0*                                 | * *   | *1,763.0*  | * *   |
| *Illinois*      | * *   | *1,190.0*  | * *   | *293.0*                                 | * *   | *1,483.0*  | * *   |
| *Minnesota*     | * *   | *1,081.6*  | * *   | *50.0*                                  | * *   | *1,131.6*  | * *   |
| *South  Dakota* | * *   | *1,016.0*  | * *   | *33.0*                                  | * *   | *1,049.0*  | * *   |
| *Indiana*       | * *   | *899.0*    | * *   | *88.0*                                  | * *   | *987.0*    | * *   |
| *Ohio*          | * *   | *470.0*    | * *   | *65.0*                                  | * *   | *535.0*    | * *   |
| *Kansas*        | * *   | *491.5*    | * *   | *20.0*                                  | * *   | *511.5*    | * *   |
| *Wisconsin*     | * *   | *498.0*    | * *   | *0.0*                                   | * *   | *498.0*    | * *   |
| *Texas*         | * *   | *250.0*    | * *   | *115.0*                                 | * *   | *365.0*    | * *   |

 

*Source: Renewable Fuels Association,January 2009*

 

Accordingly, we faceincreased competition because of the location of our ethanol plant inMinnesota.  We believe that thecompetition in the ethanol market will increase in the near term as the ethanolplants recently sold through bankruptcy proceedings return toproduction.  For example, in May 2009, Valero Energy Corporationand its subsidiaries purchased seven idle plants from VeraSun EnergyCorporation as part of VeraSun’s reorganization. Several of our competitorsincluding certain subsidiaries of Otter Tail Ag Enterprises, Pacific Ethanol, Inc.and Aventine Renewable Energy Holdings, Inc. have filed to reorganizeunder federal bankruptcy laws as a result of margin pressure, inadequateliquidity and other considerations.

 

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According to theRenewable Fuel Association (RFA), as of October 2009, 202 U.S. facilitieshave the capacity to produce approximately 13.1 billion gallons of ethanolannually. Despite the rapid increase in production, consumption of ethanol hasbeen outpacing production for the past few years, which has led to increasedimports in the United States, primarily from Brazil. According to the RFA, fromJanuary to October of 2008, the U.S. produced 7.5 billion gallons offuel ethanol and imported 515.6 million gallons. In addition to intensecompetition with local, regional and national producers of ethanol, we expectincreased competition with imported ethanol and foreign producers of ethanol.

 

*Producers of Other Fuel Additivesand Alternative Fuels*

 

In addition to competingwith ethanol producers, we also compete with producers of other gasolineoxygenates. Many gasoline oxygenates are produced by other companies, includingoil companies, that have far greater resources than we have. Historically, as agasoline oxygenate, ethanol primarily competed with two gasoline oxygenates,both of which are ether-based:  MTBE (methyl tertiary butyl ether) andETBE (ethyl tertiary butyl ether). Many states have enacted legislationprohibiting the sale of gasoline containing certain levels of MTBE or arephasing out the use of MTBE because of health and environmental concerns. As aresult, national use of MTBE has decreased significantly in recent years. Useof ethanol now exceeds that of MTBE and ETBE as a gasoline oxygenate.

 

While ethanol hasdisplaced these two gasoline oxygenates, the development of ethers intended foruse as oxygenates is continuing and we will compete with producers of anyfuture ethers used as oxygenates.

 

A number of automotive,industrial and power generation manufacturers are developing alternative fuelsand power systems, both for vehicles and other applications. Fuel cells haveemerged as a potential alternative power system to certain existing powersources because of their higher efficiency, reduced noise and lower emissions.Fuel cell industry participants are currently targeting the transportation,stationary power and portable power markets in order to decrease fuel costs,lessen dependence on crude oil and reduce harmful emissions.

 

Additionally, there aremore than a dozen alternative and advanced fuels currently in development,production or use, including the following alternative fuels that, likeethanol, have been or are currently commercially available for vehicles:

 

·                  biodiesel

·                  electricity

·                  hydrogen

·                  methanol

·                  natural gas

·                  propane

 

Several emerging fuelsare currently under development. Many of these fuels are also consideredalternative fuels and may have other benefits such as reduced emissions ordecreasing dependence upon oil. Examples of emerging fuels include:

 

·                  Biobutanol: Like ethanol, biobutanol is an alcoholthat can be produced through the processing of domestically grown crops, suchas corn and sugar beets, and other biomass, such as fast-growing grasses andagricultural waste products.

 

·                  Biogas: Biogas is produced from the anaerobicdigestion of organic matter such as animal manure, sewage, and municipal solid waste.After it is processed to required standards of purity, biogas becomes arenewable substitute for natural gas and can be used to fuel natural gasvehicles.

 

·                  Fischer-Tropsch Diesel: Diesel made by convertinggaseous hydrocarbons, such as natural gas and gasified coal or biomass, intoliquid fuel, including transportation fuel

 

·                  Hydrogenation-Derived Renewable Diesel (HDRD): Theproduct of fats or vegetable oils—alone or blended with petroleum—that has beenrefined in an oil refinery

 

·                  P-Series: A blend of natural gas liquids (pentanesplus), ethanol, and the biomass-derived co-solvent methyltetrahydrofuran(MeTHF) formulated to be used in flexible fuel vehicles

 

·                  Ultra-Low Sulfur Diesel: This is diesel fuel with 15parts per million or lower sulfur content. This ultra-low sulfur contentenables the use of advanced emission control technologies on vehicles usingULSD fuels produced from non-petroleum and renewable sources that areconsidered alternative fuels.

 

Additionally, there aredeveloped and developing technologies for converting natural gas, coal andbiomass to liquid fuel, including transportation fuels such as gasoline,diesel, and methanol.

 

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We expect thatcompetition will increase between ethanol producers, such as Heron LakeBioEnergy, LLC and producers of these or other newly developed alternativefuels or power systems, especially to the extent they are used in similarapplications such as vehicles.

 

*Producers of Distillers’ Grains*

 

The amount of distillers’grains produced annually in North America is expected to increase significantlyas the number of ethanol plants increase. We compete with other producers ofdistillers’ grains products both locally and nationally, with more intensecompetition for sales of distillers’ grains among ethanol producers in closeproximity to our ethanol plant.  Thereare 7 ethanol plants within an approximate 50 mile radius of our plant with acombined ethanol capacity of 436 mgy that will produce approximately 1.4million tons of distillers’ grains. These competitors may be more likely tosell to the same markets that we target for our distillers’ grains.

 

Additionally, distillers’grains compete with other feed formulations, including corn gluten feed, drybrewers’ grain and mill feeds. The primary value of these products as animalfeed is their protein content. Dry brewers’ grain and distillers’ grains haveabout the same protein content, and corn gluten feed and mill feeds haveslightly lower protein contents. Distillers’ grains contain nutrients, fatcontent, and fiber that we believe will differentiate our distillers’ grainsproducts from other feed formulations. However, producers of other forms ofanimal feed may also have greater experience and resources than we do and theirproducts may have greater acceptance among producers of beef and dairy cattle,poultry and hogs

 

*Competition for Corn*

 

We will compete withethanol producers in close proximity for the supplies of corn we will requireto operate our plant.  Ethanol production consumes a significant portionof Minnesota’s corn crop, approximately 30% for 2009.  The existence anddevelopment of other ethanol plants, particularly those in close proximity toour plant, will increase the demand for corn that may result in higher costsfor supplies of corn. There are 7 ethanol plants within an approximate 50 mileradius of our plant with a combined ethanol capacity of 436 mgy will useapproximately 160 million bushels of corn.

 

We compete with otherusers of corn, including ethanol producers regionally and nationally, producersof food and food ingredients for human consumption (such as high fructose cornsyrup, starches, and sweeteners), producers of animal feed and industrialusers. According to the U.S. Department of Agriculture, for 2009:  3.7billion bushels of U.S. corn was used in ethanol production, with 1.3 billionbushels being used in food and other industrial uses, and 2.0 billion bushelsused for export.

 

*Competition for Personnel*

 

We will also compete withethanol producers in close proximity for the personnel we will require tooperate our plant. The existence and development of other ethanol plants willincrease competition for qualified managers, engineers, operators and other personnel.We also compete for personnel with businesses other than ethanol producers andwith businesses located outside the community of Heron Lake, Minnesota.

.

**Hedging**

 

We may hedge anticipatedcorn purchases and ethanol and distillers’ grain sales through a variety ofmechanisms.

 

We procure corn throughspot cash, fixed-price forward, basis only, futures only, and delayed pricingcontracts. Additionally, we may use hedging positions in the corn futures andoptions market to manage the risk of excessive corn price fluctuations for aportion of our corn requirements.

 

For our spot purchases,we post daily corn bids so that corn producers can sell to us on a spot basis.Our fixed-price forward contracts specify the amount of corn, the price and thetime period over which the corn is to be delivered. These forward contracts areat fixed prices indexed to Chicago Board of Trade, or CBOT, prices. Our cornrequirements can be contracted in advance under fixed-price forward contractsor options. The parameters of these contracts are based on the local supply anddemand situation and the seasonality of the price. For delayed pricingcontracts, producers will deliver corn to our elevators, but the pricing forthat corn and the related payment will occur at a later date.

 

To hedge a portion of ourexposure to corn price risk, we may buy and sell futures and options positionson the CBOT. In addition, our facilities have significant corn storagecapacity. We generally maintain inventories of corn at our ethanol plant, butcan draw from our elevators at Lakefield and Wilder to protect against supplydisruption. At the ethanol plant, we have the ability to store approximately 10days of corn supply and our elevators have capacity for approximately anadditional 50 days of supply.

 

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We currently market all of our ethanol through C&Nand until September 2009 marketed all of our ethanol through RPMG, Inc.  Our marketers are obligated to use reasonableefforts to obtain the best price for our ethanol. To mitigate ethanol pricerisk and to obtain the best margins on ethanol that is marketed and sold by ourmarketer, we may utilize ethanol swaps, over-the-counter (“OTC”) ethanol swaps,or OTC ethanol options that are typically settled in cash, rather than gallonsof the ethanol we produce.

 

Our marketing and risk management committee,consisting of Doug Schmitz, David J. Woestehoff, Timothy O. Helgemoe, and DavidM. Reinhart, assists the board and our risk management personnel to, amongother things, establish appropriate policies and strategies for hedging andenterprise risk.

 

**Compliance with Environmental Lawsand Other Regulatory Matters**

 

Our business subjects us to various federal, state andlocal environmental laws and regulations, including those relating todischarges into the air, water and ground; the generation, storage, handling,use, transportation and disposal of hazardous materials; and the health andsafety of our employees.

 

These laws and regulations require us to obtain andcomply with numerous permits to construct and operate our ethanol plant,including water, air and other environmental permits. On March 12, 2007,we entered into an agreement with Fagen Engineering, LLC, an affiliate of Fagen, Inc.,for the development of environmental compliance programs and related services,which was completed in September 2007. On March 26, 2008, we enteredinto an agreement with Fagen Engineering, LLC for environmental compliancetraining services.

 

The costs associated with obtaining these permits andmeeting the demands of regulators reflected in the permits have increased ourcosts of construction and production. In particular, we have incurredadditional costs relating to an air-emission permit from the MinnesotaPollution Control Agency (“MPCA”). We applied for a synthetic minorair-emissions source permit in July 2004 that was granted by the MPCA in May 2005.In June 2005, a coalition of two environmental groups and one energy groupchallenged the grant of this air emissions permit by an appeal to the MinnesotaCourt of Appeals. In July 2006, the Minnesota Court of Appeals affirmedthe MPCA’s issuance of the permit. In conjunction with the permit and thepermit dispute and to prevent further appeals by the coalition, we entered intoa compliance agreement with the MPCA on January 23, 2007 that currentlygoverns the air emissions from our plant. Under the compliance agreement, weagreed to submit an amendment to our air permit to qualify our facility as a“major emissions source”. The compliance agreement also allowed us to continuewith the construction of our facility. Under the compliance agreement, weagreed to operate our facility in a manner such that the emissions of each ofthe criteria pollutants generated by our ethanol plant, as determined on a 12month rolling sum, do not exceed 95 tons per year and agreed to comply in allother respects with the air emissions permit previously issued by the MPCA.Accordingly, we submitted a major amendment to our existing air-emissionspermit in December 2008, and, following air pollution control devicetesting, we submitted a second major amendment in September 2009, bothseeking amendments to our air permit, including amendments to permit conditionsand adjustments to other components of plant operations and production.   However, we are continuing discussions withthe MPCA regarding the necessity for qualifying our facility as a majoremissions source, particularly in light of changes in federal law thatincreased the limit of certain emissions allowed as a synthetic minor source. On March 13,2008, MPCA issued a notice of violation to us for violations of certain rules,statutes, and permit conditions (as modified by the compliance agreement), includingemission violations and reporting violations. As part of our continuingdiscussions with MPCA, we are seeking to resolve these violations by agreementwith MPCA. Such resolution may result in the payment of a civil penalty orother sanctions and remedies available to MPCA. Pending the resolution of this air permit issue, wecontinue to operate subject to the compliance agreement.

 

 Other than as discussed above, we have obtainedall permits we believe are necessary for the operation of our ethanol plant.

 

Compliance with these laws and permits in the futurecould require expensive pollution control equipment or operational changes tolimit actual or potential impacts to the environment, as well as significantmanagement time and expense. A violation of these laws, regulations or permitconditions can result in substantial fines, natural resource damage, criminalsanctions, permit revocations and/or plant shutdown, any of which could have amaterial adverse effect on our operations. We have incurred costs associatedwith obtaining the air permits and costs associated with the complianceagreement of approximately $187,000 in fiscal year 2007, $208,000 in fiscalyear 2008 and $452,000 in fiscal year 2009. In addition, we have incurred costs associated with equipment failuresand/or warranty and other claims against Fagen, Inc. of approximately$2,700,000.

 

**Employees**

 

As of October 31, 2009, we had 51 full-timeemployees, of which 42 are in operations and 9 are in executive, generalmanagement and administration. We also have three part-time employees inoperations. We also have engaged Brett L. Frevert of CFO Systems, LLC as ourinterim chief financial officer on a contract basis. We do not maintain aninternal sales organization, but instead rely upon third-parties to market andsell the ethanol and distillers’ grains that we produce.

 

**Corporate Information**

 

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Our principal executive offices are located at 91246390th Avenue, Heron Lake, Minnesota 56137 and our telephone number is507-793-0077. We maintain an Internet website at www.heronlakebioenergy.com. Wemake available free of charge on or through our Internet website,www.heronlakebioenergy.com, all of our reports and all amendments to thosereports as soon as reasonably practicable after such material is electronicallyfiled with, or furnished to, the Securities and Exchange Commission (SEC). Wewill provide electronic or paper copies of these documents free of charge uponrequest.

 

Additionally, the SEC maintains an Internet site thatcontains reports, proxy and information statements, and other informationregarding issuers that file electronically with the SEC at www.sec.gov.

 

**ITEM1A.       RISK FACTORS**

 

If any of the following risks actually occur, ourresults of operations, cash flows and the value of our units could benegatively impacted.

 

**Risks Related to Our Business andOperations**

 

***We are in default of our master loan agreement with AgStarFinancial Services, PCA (“AgStar”).***

 

At October 31,2009, we were in default of covenants of our master loan agreement with AgStarrequiring us to maintain at least $5.0 million minimum working capital; atleast $39.5 million of tangible net worth; and a fixed charge ratio of 1.20 to1.00 or greater. Additionally, we do not expect to be in compliance with one ormore covenants of the master loan agreement as of fiscal year end 2010. All ofour assets and real property are subject to security interests and mortgages infavor of AgStar as security for the obligations of the master loan agreement.Our failure to maintain the required amount of working capital constitutes anevent of default under the master loan agreement, entitling the lender toaccelerate and declare due all amounts outstanding under the master loanagreement.

 

As aresult of these defaults, we have classified $49.3 in long-term debt as acurrent liability. As a result, current liabilities as of October 31, 2009totaled approximately $69.1 million, including this $49.3 million. Thiscompares to cash and cash equivalents (other than restricted cash) at October 31,2009 of approximately $3.2 million, current assets of approximately $12.9million and total assets of approximately $113.1 million. In the absence of awaiver of the covenant defaults, amendment to the master loan agreement orrefinancing of the master loan agreement, we do not have adequate capital torepay all of the amounts that would become due upon acceleration.

 

Alsopart of our master loan agreement with AgStar is a line of credit for up to$6,750,000.  Effective December 8,2009, AgStar agreed to extend the maturity date of this line of credit to February 1,2010. At October 31, 2009 and January 20, 2010, the outstandingbalance of the revolving line of credit was $5.0 million.

 

We arecurrently in negotiations with AgStar to extend the maturity of the line ofcredit and to waive the event of default arising from the failure to meet the covenantsdescribed above. In the absence of a waiver or an amendment to the line ofcredit to extend the maturity date, we do not have adequate capital to repaythe currently outstanding amounts on the line of credit. There is no assurancethat any amendment or extension of maturity will be provided by the lender orthat the line of credit, if renewed, will allow for up to $6.75 million inavailable borrowing. Further, while an event of default exists, we are notpermitted to borrow additional funds under our line of credit or revolvingterm note unless AgStar consents.

 

If wedo not receive waiver of the events of default under the master loan agreementand an extension of maturity of our line of credit, we may be required toattempt to refinance our debt, curtail significantly, or stop our businessactivities. If the lender enforces its rights under the master loan agreementto accelerate the indebtedness or proceed against our assets to collect on theindebtedness, we may lose control of our business and be forced to sell assets,restructure our indebtedness or submit to foreclosure proceedings, all of whichcould result in a material adverse effect upon our business, results ofoperations and financial condition.

 

***We are involved in a dispute with Fagen, Inc. relatingto the design-build agreement for our ethanol plant and the performanceguarantees and warranties relating to our plant, including those relating toair emissions.***

 

Ourethanol plant was constructed under a design-build agreement with Fagen, Inc.(“Fagen”) as the design-builder. We have retained approximately $3.8 million inpayments to Fagen under the design-build agreement. Under the design-buildagreement, Fagen has warranted that within six months following the date ofsubstantial completion, the emissions of our ethanol plant will meet therequirements of a synthetic minor source. Notwithstanding that we beganoperations on September 21, 2007, our plant does not yet meet thewarranties relating to air emissions and therefore, we continue to withholdapproximately $3.8 million in retainage.

 

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Wehave tested a number of possible solutions to enable our plant to meet the airemissions warranties.  To date, none of these solutions has been effectiveand there may be no solution that will allow our plant to meet the warrantiesrelating to air emissions.  Further, in testing these potential solutions,we have suffered substantial reduction in daily ethanol production and plantshutdowns as a result. As we attempt new solutions in the future, we alsoexpect that we will be required to limit production or shutdown our plant,which will impair our ability to produce ethanol and generate revenue.

 

On September 18, 2009, we commenced anarbitration action against Fagen relating to the design-build agreement and weare seeking approximately $22.8 million in damages.  Please see Part I, Item 3 “LegalProceedings” of this Form 10-K for a description of the arbitration actionagainst Fagen, Inc. relating to the design-build agreement.  In response, Fagen has assertedcounterclaims, including for payment of the approximately $3.8 million inretainage and for approximately $2.2 million in additional labor and materialsit claims it provided to us.  Inaddition, Fagen has requested to join ICM, Inc. as a party to thearbitration action.  In its response, ICMalso indicated that it intends to assert claims against us under the licenseagreement we entered into with ICM as part of the design build agreement withFagen.  We objected to Fagen’s request tojoin ICM as a party to the arbitration action.

 

Thereis no assurance that we will resolve the air emissions warranty or the disputewith Fagen to our satisfaction or that we will resolve it without significantadditional expense, including costs of our attorneys and experts in thearbitration or payments to Fagen or others as a result of the arbitration orotherwise. Additionally, we may incur additional expense because ofmodifications to our plant to achieve compliance with the air emissionswarranties, to achieve compliance with the more stringent minor sourceemissions limits, or to qualify our facility as a major emissions source. Wealso may experience increased costs of operations, even if our plant ismodified to comply with the air emissions warranty.  Our ongoing attemptsbring our plant into compliance with the warranties relating to air emissionshave had and may have in the future a material adverse effect on our business,financial condition and results of operations.

 

***Our business ishighly dependent on commodity prices, which are subject to significantvolatility and uncertainty, so our results could fluctuate significantly.***

 

We generally do not have long-term, fixed pricecontracts for the purchase of corn, our principal input, or for the sale ofethanol, our principal product. Therefore, our results of operations, financialposition and business outlook are substantially dependent on commodity prices,especially prices for corn, ethanol and unleaded gasoline. Prices for thesecommodities are generally subject to significant volatility and uncertainty. Asa result, our future financial results may fluctuate substantially.

 

In addition, we may experience periods of decliningprices for our ethanol and increasing costs for our raw materials, which couldresult in operating losses. We may attempt to offset a portion of the effectsof such fluctuations by entering into forward contracts to supply ethanol or topurchase corn, or by engaging in transactions involving options and futurescontracts. These activities involve substantial cost and substantial risk, andultimately may be ineffective in mitigating the fluctuations in corn andethanol prices.

 

***Corn prices willfluctuate and could increase significantly, which will increase our operatingcosts and could adversely affect our operating results because we generallycannot pass on increases in corn prices to our customers.***

 

Corn is the principal raw material we use to produceethanol and distillers’ grains. At certain levels, corn prices would makeethanol uneconomical to use in fuel markets. The price of corn is influenced byweather conditions (including droughts) and other factors affecting cropyields, farmers’ planting decisions and general economic, market and regulatoryfactors, including governmental policies and subsidies with respect toagriculture and international trade, and global and local supply and demand. Inparticular, increasing domestic ethanol capacity could boost demand for cornand result in increased corn prices. Any decline in the corn harvest, caused byfarmers’ planting decisions or otherwise, could cause corn prices to increaseand negatively impact our gross margins. The price of corn has fluctuatedsignificantly in the past and may fluctuate significantly in the future.Generally, we are unable to pass along increased corn costs to our customers,and accordingly, rising corn prices will tend to produce lower profit margins.

 

***Fluctuations in theselling price and production cost of gasoline may reduce our profit margins.***

 

Ethanol is marketed both as a fuel additive to reducevehicle emissions from gasoline and as an octane enhancer to improve the octanerating of gasoline with which it is blended. As a result, ethanol prices areinfluenced by the supply and demand for gasoline and our business, futureresults of operations and financial condition may be materially adverselyaffected if gasoline demand or prices decrease.

 

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***The price ofdistillers’ grains is affected by the price of other commodity products, suchas soybeans, and decreases in the price of these commodities could decrease theprice of distillers’ grains.***

 

Distillers’ grains compete with other protein-basedanimal feed products. The price of distillers’ grains may decrease when theprice of competing feed products decrease. The prices of competing animal feedproducts are based in part on the prices of the commodities from which they arederived. Downward pressure on commodity prices, such as soybeans, willgenerally cause the price of competing animal feed products to decline,resulting in downward pressure on the price of distillers’ grains. The price ofdistillers’ grains is not tied to production costs. However, decreases in theprice of distillers’ grains would result in less revenue from the sale ofdistillers’ grains and could result in lower profit margins.

 

***As more ethanolplants are built, ethanol production will increase and, if demand does notsufficiently increase, the price of ethanol and distillers’ grains maydecrease.***

 

According to the RFA, domestic ethanol productioncapacity has increased steadily from 1.5 billion gallons per year in 1999 to13.0 billion gallons per year in 2009. However, demand for ethanol may notincrease as quickly as expected or to a level that exceeds supply, or at all.Recently, several ethanol companies have announced the postponement of ethanolplants under construction due, in part, to concerns about excess productioncapacity in the ethanol industry and its impact on ethanol prices.

 

Excess ethanol production capacity also may resultfrom decreases in the demand for ethanol or increased imported supply, whichcould result from a number of factors, including regulatory developments andreduced gasoline consumption in the U.S. Reduced gasoline consumption couldoccur as a result of increased prices for gasoline or crude oil, which couldcause businesses and consumers to reduce driving or acquire vehicles with morefavorable gasoline mileage, or as a result of technological advances, such asthe commercialization of engines utilizing hydrogen fuel-cells, which couldsupplant gasoline-powered engines. There are a number of governmentalinitiatives designed to reduce gasoline consumption, including tax credits forhybrid vehicles and consumer education programs.

 

If ethanol prices decline for any reason, includingexcess production capacity in the ethanol industry, our business, results ofoperations and financial condition may be materially and adversely affected.

 

In addition, because ethanol production producesdistillers’ grains as a co-product, increased ethanol production will also leadto increased production of distillers’ grains. An increase in the supply ofdistillers’ grains, without corresponding increases in demand, could lead tolower prices or an inability to sell our distillers’ grains production. Adecline in the price of distillers’ grains or the distillers’ grains marketgenerally could have a material adverse effect on our business, results ofoperations and financial condition.

 

***Our operationscould be adversely affected by infrastructure disruptions and the price of ourethanol could be depressed by lack of adequate transportation and storageinfrastructure in certain areas.***

 

We ship our ethanol to our customers primarily by therailroad adjacent to our site. We also have the potential to receive inboundcorn via the railroad, although we currently receive corn by truck from ourfacilities in Lakefield, Minnesota and Wilder, Minnesota, each of which is lessthan 15 miles away from our plant. Our customers require appropriatetransportation and storage capacity to take delivery of the products weproduce. Therefore, our business is dependent on the continuing availability ofrail, highway and related infrastructure. Any disruptions in thisinfrastructure network, whether caused bylabor difficulties, earthquakes, storms, other natural disasters, human erroror malfeasance or other reasons, could have a material adverse effect on ourbusiness. We rely upon third-parties to maintain the rail lines from our plantto the national rail network, and any failure on their part to maintain thelines could impede our delivery of products, impose additional costs on us andcould have a material adverse effect on our business, results of operations andfinancial condition.

 

In addition, lack of this infrastructure prevents theuse of ethanol in certain areas where there might otherwise be demand andresults in excess ethanol supply in areas with more established ethanolinfrastructure, depressing ethanol prices in those areas. In order for theethanol industry to grow and expand into additional markets and for our ethanolto be sold in these new markets, there must be substantial development ofinfrastructure including:

 

·           additional rail capacity;

 

·           additional storage facilities forethanol;

 

·           increases in truck fleets capable oftransporting ethanol within localized markets;

 

·           expansion of refining and blendingfacilities to handle ethanol; and

 

·           growth in service stations equipped tohandle ethanol fuels.

 

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The substantial investments that will be required forthese infrastructure changes and expansions may not be made on a timely basis,if at all, and decisions regarding these infrastructure improvements areoutside of our control. Significant delay or failure to improve theinfrastructure that facilitates the distribution could curtail more widespreadethanol demand or reduce prices for our products in certain areas, which wouldhave a material adverse effect on our business, results of operations orfinancial condition.

 

***We face intensecompetition from competing ethanol producers.***

 

Competition in the ethanol industry is intense. Weface formidable competition in every aspect of our business from establishedproducers of ethanol, including Archer Daniels Midland Company, Cargill, Inc.,Valero Energy Corporation, and from other companies that are seeking to developlarge-scale ethanol plants and alliances. According to the RFA, the top tenproducers accounted for approximately 20% of the ethanol production capacity inthe U.S. in 2009.  Some of ourcompetitors are divisions of substantially larger enterprises and havesubstantially greater financial, operational, procurement, marketing,distribution and technical resources than we have. Additionally, smallercompetitors, such as farmer-owned cooperatives and independent companies ownedby farmers and investors, have been able to compete successfully in the ethanolindustry. Some of these competitors have business advantages, such as theability to more favorably procure corn by operating smaller plants that may notaffect the local price of corn as much as a larger-scale plant like ours orrequiring their farmer-owners to sell them corn as a requirement of ownership.A significant portion of production capacity in our industry consists ofsmaller-sized plants. We expect competition to increase, both from large andsmall competitors, as the ethanol industry becomes more widely known and demandfor ethanol increases.

 

We also face increasing competition from internationalsuppliers. Although there is a tariff on foreign-produced ethanol (which isscheduled to expire in 2010) that is roughly equivalent to the federal ethanoltax incentive, ethanol imports equivalent to up to 7.0% of total domesticproduction from certain countries are exempted from this tariff under theCaribbean Basin Initiative to spur economic development in Central America andthe Caribbean. Currently, international suppliers produce ethanol primarilyfrom sugar cane, which is a significantly more efficient raw material fromwhich to produce ethanol than corn, and have cost structures that can besubstantially lower than ours.

 

Competing ethanol producers may also introducecompetitive pricing pressures that may adversely affect our sales levels andmargins or our ability to procure corn at favorable prices. As a result, wecannot assure you that we will be able to compete successfully with existing ornew competitors.

 

***We have a limitedoperating history and a history of losses, and our business may not be successful.***

 

We were organized as a Minnesota limited liabilitycompany in April 2001 and did not begin producing ethanol until September 21,2007. In October 2007, we began recording revenues from our ethanolproduction activity. Accordingly, we have a limited operating history fromwhich to evaluate our business and prospects. Despite net income ofapproximately $8.6 million in fiscal year 2008, we have incurred a net loss forfiscal year 2007 of $5.4 million and a net loss for fiscal year 2009 of $11.3million.

 

Our prospects must be considered in light of the risksand uncertainties encountered by an early-stage company and in a rapidlyevolving market, such as the ethanol market, where supply and demand may changesignificantly in a short period of time. In addition, most of our governors andexecutive officers have no expertise in the ethanol industry or governing andoperating a public company. While our governors and executive officers areexperienced in business generally, their lack of experience in the ethanolindustry and managing a public company may present additional risks to ourbusiness.

 

Some of the risks and uncertainties we may encounterrelate to our potential inability to:

 

·           effectively manage our business andoperations, in particular the pricing risks inherent in the sale of ethanol andpurchase of corn;

 

·           comply with federal and stateenvironmental laws and regulations;

 

·           recruit and retain key personnel;

 

·           comply with our obligations as a publicreporting company while maintaining a low-cost structure; and

 

·           address the other risks describedthroughout this annual report on Form 10-K.

 

If we cannot successfully address these risks, ourbusiness, future results of operations and financial condition may bematerially adversely affected.

 

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***Certain provisions of our masterloan agreement with AgStar present special risks to our business.***

 

As of October 31, 2009, our debt with AgStarconsists of approximately $40.8 million in fixed rate obligations and $18.7million in variable rate obligations after giving effect to our election underour master loan agreement with AgStar to fix an interest rate of 6.58% on $45.0million of our debt effective May 1, 2008 through April 30, 2011. Thevariable rate on a portion of our debt may make us vulnerable to increases inprevailing interest rates. If the interest rate on our variable rate debt wereto increase, our aggregate annualized interest and principal payments wouldalso increase and could increase significantly.

 

The principal and interest payments on our $53.4million term loan are calculated using an amortization period of ten years eventhough the note will mature on October 1, 2012, five years from the dateof its issuance. As a result, at maturity of the term loan, there would beapproximately $38.9 million in principal remaining under the term loan, withoutany additional payments that may be required under the master loan agreement.In order to finance this large payment of principal that would be due atmaturity, we may attempt to extend the term of the loan under the master loanagreement, refinance the indebtedness under the master loan agreement, in fullor in part, or obtain a new loan to repay the term loan. We cannot assure youthat will be successful in obtaining an extension of or refinancing ourindebtedness. We also cannot assure you that we will be able to obtain a newloan in an amount that is sufficient for our needs, in a timely manner or onterms and conditions acceptable to us or our members.

 

We also have a $4.0 million revolving term loan. As ofOctober 31, 2009, we have used approximately $1.1 million of AgStar’scommitment under this loan. The loan will mature on October 1, 2012. Aswith the term loan, at maturity we may attempt to extend, refinance, or obtaina new loan to repay any outstanding balance. We cannot assure you that anyalternative will be sufficient for our needs, available in a timely manner oron terms and conditions acceptable to us or our members.  We cannot draw on the unused portion of thisdebt as long as we are not in compliance with the covenants of our master loanagreement.

 

If we are unable to service our debt, we may losecontrol of our business and be forced to reduce or delay planned capitalexpenditures, sell assets, restructure our indebtedness or submit toforeclosure proceedings, all of which would result in a material adverse effectupon our business.

 

***We engage inhedging transactions which involve risks that can harm our business.***

 

In an attempt to offset some of the effects ofvolatility of ethanol prices and corn costs, we may enter into cash fixed-pricecontracts to sell a portion of our ethanol and distillers’ grains production orpurchase a portion of our corn requirements. We may use exchange-traded futurescontracts and options to manage commodity risk. The impact of these activitiesdepends upon, among other things, the prices involved and our ability to sellsufficient products to use all of the corn for which we have futures contracts.Hedging arrangements also expose us to the risk of financial loss in situationswhere the other party to the hedging contract defaults on its contract or, inthe case of exchange-traded contracts, where there is a change in the expecteddifferential between the underlying price in the hedging agreement and theactual prices paid or received by us. Hedging activities can themselves resultin losses when a position is purchased in a declining market or a position issold in a rising market. A hedge position is often settled in the same timeframe as the physical commodity is either purchased (corn) or sold (ethanol).We may experience hedging losses in the future. We also vary the amount ofhedging or other price mitigation strategies we undertake, and we may choosenot to engage in hedging transactions at all. As a result, whether or not weengage in hedging transactions, our business, results of operations andfinancial condition may be materially adversely affected by increases in theprice of corn or decreases in the price of ethanol.

 

***Operationaldifficulties at our plant could negatively impact our sales volumes and couldcause us to incur substantial losses.***

 

Our operations are subject to labor disruptions,unscheduled downtime and other operational hazards inherent in our industry,such as equipment failures, fires, explosions, abnormal pressures, blowouts,pipeline ruptures, transportation accidents and natural disasters. Some ofthese operational hazards may cause personal injury or loss of life, severedamage to or destruction of property and equipment or environmental damage, andmay result in suspension of operations and the imposition of civil or criminalpenalties. Our insurance may not be adequate to fully cover the potentialoperational hazards described above or we may not be able to renew this insuranceon commercially reasonable terms or at all. Furthermore, we may have difficultymanaging the necessary process maintenance required to maintain our nameplateproduction capacity of 50 mgy. If our ethanol plant does not produce ethanoland distillers’ grains at the levels we expect, our business, results ofoperations, and financial condition may be materially adversely affected.

 

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***Competition forqualified personnel in the ethanol industry is intense and we may not be ableto hire and retain qualified personnel to operate our ethanol plant.***

 

Our success depends in part on our ability to attractand retain competent personnel. For our ethanol plant, we must hire qualifiedmanagers, operations personnel, accounting staff and others, which can bechallenging in a rural community. Competition for employees in the ethanolindustry is intense, and we may not be able to attract and retain qualifiedpersonnel. If we are unable to hire productive and competent personnel andretain our existing personnel, our business may be adversely affected and we maynot be able to efficiently operate our ethanol business and comply with ourother obligations.

 

***Technology in ourindustry evolves rapidly, potentially causing our plant to become obsolete, andwe must continue to enhance the technology of our plant or our business maysuffer.***

 

We expect that technological advances in the processesand procedures for processing ethanol will continue to occur. It is possiblethat those advances could make the processes and procedures that we utilize atour ethanol plant less efficient or obsolete. These advances could also allowour competitors to produce ethanol at a lower cost than we are able. If we areunable to adopt or incorporate technological advances, our ethanol productionmethods and processes could be less efficient than those of our competitors,which could cause our ethanol plant to become uncompetitive.

 

Ethanol production methods are constantly advancing.The current trend in ethanol production research is to develop an efficientmethod of producing ethanol from cellulose-based biomass such as agriculturalwaste, forest residue and municipal solid waste. This trend is driven by thefact that cellulose-based biomass is generally cheaper than corn and producingethanol from cellulose-based biomass would create opportunities to produceethanol in areas that are unable to grow corn. Another trend in ethanolproduction research is to produce ethanol through a chemical or thermalprocess, rather than a fermentation process, thereby significantly increasingthe ethanol yield per pound of feedstock. Although current technology does notallow these production methods to be financially competitive, new technologiesmay develop that would allow these methods to become viable means of ethanolproduction in the future. If we are unable to adopt or incorporate theseadvances into our operations, our cost of producing ethanol could besignificantly higher than those of our competitors, which could make ourethanol plant obsolete. Modifying our plant to use the new inputs and technologieswould likely require material investment.

 

***If ethanol fails tocompete successfully with other existing or newly-developed oxygenates orrenewable fuels, our business will suffer.***

 

Alternative fuels, additives and oxygenates arecontinually under development. Alternative fuels and fuel additives that canreplace ethanol are currently under development, which may decrease the demandfor ethanol. Technological advances in engine and exhaust system design andperformance could reduce the use of oxygenates, which would lower the demandfor ethanol, and our business, results of operations and financial conditionmay be materially adversely affected.

 

***Ourlevel of indebtedness may adversely affect our ability to react to changes inour business, and we may be limited in our ability to refinance our existingdebt or use debt to fund future capital needs.***

 

We have a substantialamount of indebtedness.  Because of oursubstantial debt, demands on our cash resources are higher than they otherwisewould be which could negatively impact our business, results of operations andfinancial condition.  As a result of oursubstantial indebtedness, we may be more vulnerable to general adverse economicand industry conditions. We may find it more difficult to obtain additionalfinancing to fund future working capital, capital expenditures and othergeneral operating requirements. We will be required to dedicate a substantialportion of our cash flow from operations to the payment of principal andinterest on our debt, reducing the available cash flow to manage our corn andethanol price risk, fund operations or make capital expenditures. We may have acompetitive disadvantage relative to other companies in our industry with lessdebt.  We may also experience decreases inour regular trade credit from vendors, which could adversely impact our cashflow if we need to start prepaying for items we have been able to purchase ontrade credit in the past.  In early 2007,a crisis began in the subprime mortgage sector, as a result of risingdelinquencies and credit quality deterioration, and has subsequently spreadthroughout the credit market. There can be no assurances that this creditcrisis will not worsen or impact our availability and cost of debt financingincluding with respect to any refinancings.

 

***The EPA imposed E10 “blend wall”if not overcome will have an adverse affect on demand for ethanol.***

 

We believe that the E10 “blend wall” is one of themost critical governmental policies currently facing the ethanolindustry.  The “blend wall” issue arises because of severalconflicting requirements.  First, the renewable fuels standardsdictate a continuing increase in the amount of ethanol blended into thenational gasoline supply.  Second, the Environmental ProtectionAgency (EPA) mandates a limit of 10% ethanol inclusion in non-flex fuelvehicles, and the E85 vehicle marketplace is struggling to grow due to lackinginfrastructure.  Total gasoline usage by the U.S. is currently around138 billion gallons, and is expected to decrease to less than 130 billiongallons over the next 5 years as fuel mileage 

 

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standards are changed. The RFS dictates an increasing amount of ethanol blending:  13.95 billion gallons in 2011, 15.2 billiongallons in 2012, and increasing to 36 billion gallons by 2022.  To reach the standard as dictated by the RFSin 2011, assuming 135 billion gallons of total gasoline usage nationally, eachgallon of gasoline sold would have to be blended with greater than 10% ethanol.  The EPA policy of 10% and the RFS increasingblend rate are at odds, which is sometimes referred to as the “blend wall.”  One industry group has petitioned the EPA fora waiver of the E10 law and an increase to E15. The EPA has currently postponed the expected December 2009decision.  This issue is a major risk tothe ethanol industry.

 

***We are subject tofinancial reporting and other requirements for which our accounting, internalaudit and other management systems and resources may not be adequatelyprepared.***

 

We are subject to reporting and other obligationsunder the Securities Exchange Act of 1934, as amended, or the Exchange Act.Only one of our governors and our interim chief financial officer has served assuch with a company that is required to file reports under the Exchange Act.These reporting and other obligations will place significant demands on ourmanagement, administrative, operational, and accounting resources. As a result,we may not be able or qualified to efficiently manage our financial accountingand preparation of the Exchange Act reports. If we are unable to manage ourfinancial accounting and prepare our Exchange Act reports, we may be exposed tosignificant liabilities and have difficulty raising additional capital.

 

***Our failure toachieve and maintain effective internal controls over financial reporting mayhave a material effect on our business.***

 

We are in the process of upgrading our systems,implementing additional financial and management controls, and reportingsystems and procedures.  We are currently preparing for compliance withthe reporting requirement of Section 404 of the Sarbanes-Oxley Act of2002. This effort, under the direction of senior management, includesdocumentation, and testing of our controls and business processes. We arecurrently in the process of formalizing an internal control audit plan thatincludes performing a risk assessment, establishing a reporting methodology andtesting internal controls and procedures over financial reporting.  Someof these efforts to prepare for the reporting requirement have resulted inchanges to our internal control over financial reporting.

 

However, there has been no change in our internalcontrol over financial reporting (as defined in Rule 13a-15(f) underthe Exchange Act) that occurred in the fiscal year ended October 31, 2009that has materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

 

***Certain of ourmembers exert significant influence over us. Their interests may not coincidewith ours or the interests of our unitholders, and they may make decisions withwhich we or our unitholders may disagree.***

 

As of January 1, 2010, Project Viking, LLCbeneficially owned 21.8% of our outstanding units. Project Viking is owned byRoland J. (Ron) Fagen and Diane Fagen, the principal shareholders of Fagen, Inc.,our design-build firm. Project Viking, together with our executive officers andgovernors, together control approximately 25.8% of our outstanding units as of January 1,2010. As a result, these unitholders, acting individually or together, couldsignificantly influence our management and affairs and all matters requiringmember approval, including the election of governors and approval ofsignificant corporate transactions. This concentration of ownership may alsohave the effect of delaying or preventing a change in control of our companyand might affect the market price of our units.

 

The interests of thesemembers may not coincide with our interests or the interests of our othermembers. For example, Fagen, Inc. has invested and may continue to investin a number of other ethanol producers, some of whom may compete with us.  Additionally, in September 2005, weentered into a design-build agreement with Fagen, Inc. for theconstruction of our plant.    In September 2009,we commenced an arbitration action against Fagen, Inc. relating to itsdesign-build agreement with us.  Pleasesee Part I, Item 3 “Legal Proceedings” of this Form 10-K for adescription of this arbitration action. This dispute is another instance in which our interests and those ofProject Viking and the Fagen affiliates are not aligned.

 

As a result of these and other potential conflictinginterests, these existing members may make decisions with respect to us withwhich we or our members may disagree.

 

***Because we areprimarily dependent upon one product, our business is not diversified, and wemay not be able to adapt to changing market conditions or endure any decline inthe ethanol industry.***

 

Our success depends on our ability to efficientlyproduce and sell ethanol, and, to a lesser extent, distillers’ grains. We donot have any other lines of business or other significant sources of revenue torely upon if we are unable to produce and sell ethanol and distillers’ grains,or if the market for those products decline. Our lack of diversification meansthat we may not be able to adapt to changing market conditions, changes inregulation, increased competition or any significant decline in the ethanolindustry.

 

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***Our sales will decline, and ourbusiness will be materially harmed if our third party marketers do noteffectively market or sell the ethanol and distillers grains we produce or ifthere is a significant reduction or delay in orders from our marketers.***

 

We have entered into an agreement with a third partyto market our supply of ethanol.  We havealso entered into an agreement with another third party to market our supply ofdistillers grains.  Our marketers areindependent businesses that we do not control. We cannot be certain that thesemarketers will market or sell our ethanol and distillers’ grains effectively.Our agreements with these marketers do not contain requirements that a certainpercentage of such parties’ sales are of our products, nor do the agreementsrestrict their ability to choose alternative sources for ethanol or distillersgrains.

 

Our success in achieving revenue from the sale ofethanol and distillers grains will depend upon the continued viability andfinancial stability of our marketers. These marketers may choose to devotetheir efforts to other ethanol producers or reduce or fail to devote thenecessary resources to provide effective sales and marketing support of ourproducts. We believe that our financial success will continue to depend inlarge part upon the success of our marketers in operating theirbusinesses.  If these marketers do noteffectively market and sell our ethanol and distillers grains, our revenues maydecrease and our business will be harmed.

 

***Our business issubject to extensive occupational safety and health regulations that couldincrease our operating costs.***

 

We are subject to various occupational safety andhealth regulations, and we have incurred expense in training employees inoccupational safety compliance.  We will continue to be subject to suchsafety and health regulations and will continue to incur expense with respectto training and compliance.  We do not expect that compliance with these rules andregulations will have a material impact on our business or as to ourcompetitive stance in the industry, as these rules apply to other ethanolplants as well.  However, any increase in OSHA compliance costs couldnegatively affect our profitability.

 

***Approval of a LowCarbon Fuel Standard (“LCFS”) by the California Air Resources Board (“CARB”)may have a negative impact on our ability to market our ethanol in California.***

 

The CARB recently proposed rules to implement aLCFS, which would set standards for the carbon intensity of fuels used in theState of California starting in 2011.  While the proposed rules arestill subject to rulemaking process in California, certain provisions of theproposed LCFS rules have the potential to ban ethanol produced at ourplant from being sold in California.  While we believe there may besome negative impact to our sales from the approval of the LCFS in California,we believe we will still be able to market all the ethanol produced by ourplant.  However, if additional states where our ethanol is marketed,or the federal government, adopt similar provisions it could have a severenegative impact on our ability to sell all of the ethanol produced at ourplant.

 

**Risks Related to the Units**

 

***There is no publicmarket for our units and no public market is expected to develop.***

 

There is no established public trading market for ourunits, and we do not expect one to develop in the foreseeable future. Tomaintain our partnership tax status, we do not intend to list the units on anystock exchange or automatic quotation system such as OTC Bulletin Board. As aresult, units held by our members may not be easily resold and members may berequired to hold their units indefinitely. Even if members are able to resellour units, the price may be less than the members’ investment in the units ormay otherwise be unattractive to the member.

 

***There aresignificant restrictions on the transfer of our units.***

 

To protect our status as a partnership for taxpurposes and to assure that no public trading market in our units develops, ourunits are subject to significant restrictions on transfer and transfers aresubject to approval by our board of governors. All transfers of units mustcomply with the transfer provisions of our Member Control Agreement and theunit transfer policy adopted by our board of governors. Our board of governorswill not approve transfers which could cause us to lose our tax status orviolate federal or state securities laws. On November 5, 2008, our boardof governors adopted a revised unit transfer policy. While the revised policypermits transfers of our units under certain circumstances, including certaintransfers of units for value, there continue to be significant restrictions ontransfer of our units. Among other things, the revised unit transfer policy placeslimits on the number of units that may be transferred during any fiscal yearand requires the transferor and transferee to complete a unit transferagreement and application form and submit these to us along with the requireddocuments and an application fee. As a result, members may not be able totransfer their units and may be required to assume the risks of the investmentfor an indefinite period of time.

 

A transferee may be admitted as a member only uponapproval by the board of governors and upon satisfaction of certain otherrequirements, including the transferee meeting the minimum unit ownershiprequirements to become a member (which for our present units requires holding aminimum of 2,500 units). Any transferee that is not admitted as a member willbe deemed an unadmitted assignee. An 

 

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unadmitted assignee will be a non-member unit holderand will have the same financial rights as other unit holders, such as theright to receive distributions that we declare or that are available upon ourdissolution or liquidation. As a non-member unit holder, an unadmitted assigneewill not have the voting or other governance rights of members and will not beentitled to any information or accountings regarding our business or to inspectour books and records.

 

***There is noassurance that we will be able to make distributions to our unit holders, whichmeans that holders could receive little or no return on their investment.***

 

Distributions of our net cash flow may be made at thesole discretion of our board of governors, subject to the provisions of theMinnesota Limited Liability Company Act, our Member Control Agreement andrestrictions imposed by our creditors. There is no assurance that we willgenerate any distributable cash from operations. Although our intention is tomake cash distributions sufficient to discharge our members’ anticipated taxliabilities arising from any taxable income generated, our board may elect toretain cash for operating purposes, debt retirement, plant improvements orexpansion. Consequently, members may receive little or no return on theirinvestment in the units.

 

***We may authorizeand issue units of new classes which could be superior to or adversely affectholders of our outstanding units.***

 

Our board of governors, upon the approval of amajority in interest of our members, has the power to authorize and issue unitsof classes which have voting powers, designations, preferences, limitations andspecial rights, including preferred distribution rights, conversion rights,redemption rights and liquidation rights, different from or superior to thoseof our present units. New units may be issued at a price and on termsdetermined by our board of governors. The terms of the units and the terms ofissuance of the units could have an adverse impact on your voting rights andcould dilute your financial interest in us.

 

***Our use of astaggered board of governors and allocation of governor appointment rights mayreduce the ability of investors to affect the composition of the board.***

 

We are managed by a board of governors, currentlyconsisting of eight elected governors and two appointed governors. The seats onthe board that are not subject to a right of appointment will be elected by theother members. The initial board designated from among themselves three classesof governors. The terms of the three classes of governors is staggered suchthat, beginning in 2008, our members will elect one-third (or as nearly aspossible) of the non-appointed members of the board of governors annually. Anappointed governor serves indefinitely at the pleasure of the member appointinghim or her (so long as such member and its affiliates continue to hold asufficient number of units to maintain the applicable appointment right) untila successor is appointed, or until the earlier death, resignation or removal ofthe appointed governor.

 

The effect of these provisions may make it moredifficult for a third party to acquire, or may discourage a third party fromacquiring, control of us and may discourage attempts to change our management,even if an acquisition or these changes would be beneficial to our members.

 

***Our units representboth financial and governance rights, and loss of status as a member wouldresult in the loss of the holder’s voting and other rights and would allow usto redeem such holder’s units.***

 

Holders of units are entitled to certain financialrights, such as the right to any distributions, and to governance rights, suchas the right to vote as a member. If a unit holder does not continue to qualifyas a member or such holder’s member status is terminated, the holder would losecertain rights, such as voting rights, and we could redeem such holder’s units.The minimum number of units presently required for membership is 2,500 units.In addition, holders of units may be terminated as a member if the holder diesor ceases to exist, violates our Member Control Agreement or takes actionscontrary to our interests, and for other reasons. Although our Member ControlAgreement does not define what actions might be contrary to our interests, andour board of governors has not adopted a policy on the subject, such actionsmight include providing confidential information about us to a competitor,taking a board or management position with a competitor or taking action whichresults in significant financial harm to us in the marketplace. If a holder ofunits is terminated as a member, our board of governors will have no obligationto redeem such holder’s units.

 

***Voting rights ofmembers are not necessarily equal and are subject to certain limitations.***

 

Members of our company are holders of units who havebeen admitted as members upon their investment in our units and who areadmitted as members by our board of governors. The minimum number of unitsrequired to retain membership is 2,500 units. Any holder of units who is not amember will not have voting rights. Transferees of units must be approved byour board of governors to become members. Members who are holders of ourpresent units are entitled to one vote for each unit held. The provisions ofour Member Control Agreement relating to voting rights applicable to any classof units will apply equally to all units of that class. However, our MemberControl Agreement gives members who hold significant amounts of equity in usthe right to designate governors to serve on our board of governors. For every9% 

 

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of our units held, the member has the right to appointone person to our board. Project Viking, LLC has the right to appoint twopersons to our board pursuant to this provision. If units of any other classare issued in the future, holders of units of that other class will have thevoting rights that are established for that class by our board of governorswith the approval of our members. Consequently, the voting rights of membersmay not be completely proportional to the number of units held. Cumulativevoting for governors is not allowed, which makes it substantially less likelythat a minority of members could elect a member to the board of governors.Members do not have dissenter’s rights. This means that they will not have theright to dissent and seek payment for their units in the event we merge,consolidate, exchange or otherwise dispose of all or substantially all of ourproperty. Holders of units who are not members have no voting rights. Theseprovisions may limit the ability of members to change the governance andpolicies of our company.

 

***All members will bebound by actions taken by members holding a majority of our units, and becauseof the restrictions on transfer and lack of dissenters’ rights, members couldbe forced to hold a substantially changed investment.***

 

We cannot engage in certain transactions, such as amerger, consolidation, dissolution or sale of all or substantially all of ourassets, without the approval of our members. However, if holders of a majorityof our units approve a transaction, then all members will also be bound to thattransaction regardless of whether that member agrees with or voted in favor ofthe transaction. Under our Member Control Agreement, members will not have anydissenters’ rights to seek appraisal or payment of the fair value of theirunits. Consequently, because there is no public market for the units, membersmay be forced to hold a substantially changed investment.

 

**Government and Regulatory Risks**

 

***Federal and stateregulation heavily influence the ethanol industry and changes in governmentregulation that adversely affect the demand for or supply of ethanol will havea material adverse effect on our business.***

 

Various federal and state laws, regulations andprograms impact the supply of and demand for ethanol. Some governmentregulation, for example those that provide economic incentives to ethanolproducers, stimulate supply of ethanol by encouraging production and theincreased capacity of ethanol plants. Others, such as a federal excise taxincentive program that provides gasoline distributors who blended ethanol withgasoline to receive a federal excise tax rate reduction for each blended gallonthey sell, stimulate demand for ethanol by making it price competitive withother oxygenates. Further, tariffs generally apply to the import of ethanolfrom certain other countries, where the cost of production can be significantlyless than in the U.S. These tariffs are designed to increase the cost ofimported ethanol to a level more comparable to the cost of domestic ethanol byoffsetting the benefit of the federal excise tax program. Tariffs have theeffect of maintaining demand for domestic ethanol. Additionally, the federalgovernment has established renewable fuels standard (RFS) programs, mostrecently under the Energy Independence and Security Act of 2007, which setminimum national standards for use of renewable fuels. The RFS and other stateprograms that require or provide incentives for the use of ethanol createdemand for ethanol. Government regulation and government programs that createdemand for ethanol may also indirectly create supply for ethanol as additionalproducers expand or new companies enter the ethanol industry to capitalize ondemand.

 

Federal and state laws, regulations and programs areconstantly changing. We cannot predict what material impact, if any, thesechanges might have on our business. Future changes in regulations and programscould impose more stringent operational requirements or could reduce oreliminate the benefits we receive, directly and indirectly, under currentregulations and programs. Future changes in regulations and programs may increaseor add benefits to ethanol producers other than us or eliminate or reducetariffs or other barriers to entry into the U.S. ethanol market, any of whichcould prove beneficial to our competitors, both domestic and international.Future changes in regulation may also hurt our business by providing economicincentives to producers of other renewable fuels or oxygenates or encouraginguse of fuels or oxygenates that compete with ethanol. In addition, bothnational and state regulation is influenced by public opinion and changes inpublic opinion. For example, certain states oppose the use of ethanol because,as net importers of ethanol from other states, the use of ethanol couldincrease gasoline prices in that state and because that state does not receive significanteconomic benefits from the ethanol industry, which are primarily experienced bycorn and ethanol producing states. Further, some argue that the use of ethanolwill have a negative impact on gasoline prices to consumers, result in risingfood prices, add to air pollution, harm car and truck engines, and actually usemore fossil energy, such as oil and natural gas, than the amount of ethanolthat is produced. We cannot predict the impact that opinions of consumers,legislators, industry participants, or competitors may have on the regulationsand programs currently benefiting ethanol producers.

 

***We may be adverselyaffected by environmental laws, regulations and liabilities.***

 

We are subject to various federal, state and localenvironmental laws and regulations, including those relating to the dischargeof materials into the air, water and ground.

 

Some of these laws and regulations require our plantto operate under permits that are subject to renewal or modification. Theselaws, regulations and permits may require pollution control equipment oroperational changes to limit actual or potential impacts to the environment.

 

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The costsassociated with obtaining and complying with permits and complying withenvironmental laws have increased our costs of construction and production. Inparticular, we have incurred additional costs relating to an air-emissionpermit from the Minnesota Pollution Control Agency (“MPCA”). We applied for asynthetic minor air-emissions source permit in July 2004 that was grantedby the MPCA in May 2005. In June 2005, a coalition of twoenvironmental and one energy group challenged the grant of this air emissionspermit by an appeal to the Minnesota Court of Appeals and in July 2006,the Minnesota Court of Appeals affirmed the MPCA’s issuance of the permit. Inconjunction with the permit and the permit dispute and to prevent furtherappeals by the coalition, we entered into a compliance agreement with the MPCAon January 23, 2007 that currently governs the air emissions from ourplant. Under the compliance agreement, we also agreed to submit an amendment toour air permit to qualify our facility as a “major emissions source”.Accordingly, we submitted a major amendment to our existing air-emissionspermit in December 2008, and, following air pollution control devicetesting, we submitted a second major amendment in September 2009, bothseeking amendments to our air permit, including amendments to permit conditionsand adjustments to other components of plant operations and production.  However, we are continuing discussions withthe MPCA regarding the necessity for qualifying our facility as a majoremissions source, particularly in light of changes in federal law thatincreased the limit of certain emissions allowed as a synthetic minorsource.  On March 13, 2008, MPCA issued anotice of violation to us for violations of certain rules, statutes, and permitconditions (as modified by the compliance agreement), including emissionviolations and reporting violations.  Aspart of our continuing discussions with MPCA, we are seeking to resolve theseviolations by agreement with MPCA.  Suchresolution may result in the payment of a civil penalty or other sanctions andremedies available to MPCA.  Pending theresolution of this air permit issue, we continue to operate subject to thecompliance agreement.

 

In September 2009, we commenced an arbitrationaction against Fagen, Inc. relating to its design-build agreement with usand in particular, the failure of our ethanol plant to comply with airemissions guarantees and warranties. Please see Part I, Item 3 “Legal Proceedings” of this Form 10-Kfor a description of this arbitration action.

 

There can be no assurance that we will be able tocomply with any of the conditions of the compliance agreement, any of our otherpermits, or with environmental laws applicable to us. Compliance with theselaws and permits could require expensive pollution control equipment oroperational changes to limit actual or potential impacts to the environment, aswell as significant management time and expense.  However, if the requested air permitmodification is granted without change by the MPCA, it will substantiallyincrease our ability to operate consistently at or below limitations as asynthetic minor source. The resolution of our air emissions permit issue willlikely involve significant management time and expense and may involve ongoingoperational expense or further modifications to the design or equipment in ourplant. There can be no assurance that we will succeed in our discussions withthe MPCA to qualify our ethanol plant as a minor emissions source. A violationof environmental laws, regulations or permit conditions can result insubstantial fines, natural resource damage, criminal sanctions, permitrevocations or plant shutdown, any of which could have a material adverseeffect on our operations.

 

Federal and state regulations affecting the operationof our ethanol plant are subject to future change. We cannot predict whatmaterial impact, if any, these changes might have on our business. Futurechanges in regulations or enforcement policies could impose more stringentrequirements on us, compliance with which could require additional capitalexpenditures, increase our operating costs or otherwise adversely affect ourbusiness. These changes may also relax requirements that could prove beneficialto our competitors and thus adversely affect our business. In addition,regulations of the EPA and the MCPA depend heavily on administrativeinterpretations. We cannot assure you that future interpretations made by theEPA, or other regulatory authorities, with possible retroactive effect, willnot adversely affect our business, financial condition and results ofoperations.

 

We also plan to evaluate the effectiveness of thecurrent emissions monitoring system in preparation for possible green house gasemissions regulatory changes. Being able to monitor emissions more effectivelycould lead to further reductions in emissions which would lead to lower fees.Reductions in emissions can make us a better environmental company. Byattempting to adjust to possible upcoming regulatory changes, we hope to bebetter positioned to take advantage of the changes from the beginning.  We believe that all companies will be facedwith higher fees for future emissions based on recent federal legislativeproposals.

 

Failure to comply with existing or future regulatoryrequirements could have a material adverse effect on our business, financialcondition and results of operations.

 

**Risks Related to Tax Issues in aLimited Liability Company**

 

**EACH UNIT HOLDER SHOULD CONSULT THEINVESTOR’S OWN TAX ADVISOR WITH RESPECT TO THE FEDERAL AND STATE TAXCONSEQUENCES OF AN INVESTMENT IN HERON LAKE BIOENERGY, LLC AND ITS IMPACT ONTHE INVESTOR’S TAX REPORTING OBLIGATIONS AND LIABILITY.**

 

***If we are not taxedas a partnership, we will pay taxes on all of our net income and you will betaxed on any earnings we distribute, and this will reduce the amount of cashavailable for distributions to holders of our units.***

 

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We consider Heron Lake BioEnergy, LLC to be apartnership for federal income tax purposes. This means that we will not payany federal income tax, and our members will pay tax on their share of our netincome. If we are unable to maintain our partnership tax treatment or qualifyfor partnership taxation for whatever reason, then we may be taxed as acorporation. We cannot assure you that we will be able to maintain ourpartnership tax classification. For example, there might be changes in the lawor our company that would cause us to be reclassified as a corporation. As acorporation, we would be taxed on our taxable income at rates of up to 38% forfederal income tax purposes. Further, distributions would be treated asordinary dividend income to our unit holders to the extent of our earnings andprofits. These distributions would not be deductible by us, thus resulting indouble taxation of our earnings and profits. This would also reduce the amountof cash we may have available for distributions.

 

***Your tax liabilityfrom your allocated share of our taxable income may exceed any cashdistributions you receive, which means that you may have to satisfy this taxliability with your personal funds.***

 

As a partnership for federal income tax purposes, allof our profits and losses “pass-through” to our unit holders. You must pay taxon your allocated share of our taxable income every year. You may incur taxliabilities from allocations of taxable income for a particular year or in theaggregate that exceed any cash distributions you receive in that year or in theaggregate. This may occur because of various factors, including but not limitedto, accounting methodology, the specific tax rates you face, and payment obligationsand other debt covenants that restrict our ability to pay cash distributions.If this occurs, you may have to pay income tax on your allocated share of ourtaxable income with your own personal funds.

 

***You may not be ableto fully deduct your share of our losses or your interest expense.***

 

It is likely that your interest in us will be treatedas a “passive activity” for federal income tax purposes. In the case of unitholders who are individuals or personal services corporations, this means thata unit holder’s share of any loss incurred by us will be deductible onlyagainst the holder’s income or gains from other passive activities, e.g., Scorporations and partnerships that conduct a business in which the holder isnot a material participant. Some closely held C corporations have morefavorable passive loss limitations. Passive activity losses that are disallowedin any taxable year are suspended and may be carried forward and used as anoffset against passive activity income in future years. Upon disposition of ataxpayer’s entire interest in a passive activity to an unrelated person in ataxable transaction, suspended losses with respect to that activity may then bededucted.

 

Interest paid on any borrowings incurred to purchaseunits may not be deductible in whole or in part because the interest must beaggregated with other items of income and loss that the unit holder hasindependently experienced from passive activities and subjected to limitationson passive activity losses.

 

***You may be subjectto federal alternative minimum tax***

 

Individual taxpayers are subject to an “alternativeminimum tax” if that tax exceeds the individual’s regular income tax. Foralternative minimum tax purposes, an individual’s adjusted gross income isincreased by items of tax preference. We may generate such preference items,the most significant of which is accelerated depreciation. Accordingly,preference items from our operations together with other preference items youmay have may cause or increase an alternative minimum tax to a unit holder. Youare encouraged and expected to consult with your individual tax advisor toanalyze and determine the effect on your individual tax situation of thealternative minimum taxable income you may be allocated, particularly in the earlyyears of our operations.

 

***Preparation of yourtax returns may be complicated and expensive.***

 

The tax treatment of limited liability companies andthe rules regarding partnership allocations are complex. We will file apartnership income tax return and will furnish each unit holder with a ScheduleK-1 that sets forth our determination of that unit holder’s allocable share ofincome, gains, losses and deductions. In addition to UnitedStates federal income taxes, unit holderswill likely be subject to other taxes, such as state and local taxes, that areimposed by various jurisdictions. It is the responsibility of each unit holderto file all applicable federal, state and local tax returns and pay allapplicable taxes. You may wish to engage a tax professional to assist you inpreparing your tax returns and this could be costly to you.

 

***Any audit of ourtax returns resulting in adjustments could result in additional tax liabilityto you.***

 

The IRS may audit our tax returns and may disagreewith the positions that we take on our returns or any Schedule K-1. If any ofthe information on our partnership tax return or a Schedule K-1 is successfullychallenged by the IRS, the character and amount of items of income, gains,losses, deductions or credits in a manner allocable to some or all our unitholders may change in a manner that adversely affects those unit holders. Thiscould result in adjustments on unit holders’ tax returns and in additional taxliabilities, penalties and interest to you. An audit of our tax returns couldlead to separate audits of your personal tax returns, especially if adjustmentsare required.

 

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**ITEM 1B.**                                                                    **UNRESOLVED STAFFCOMMENTS**

 

Not applicable.

 

**ITEM2.**                                                                             **PROPERTIES**

 

We own approximately 216 acres of land located nearHeron Lake, Minnesota on which we have constructed our ethanol plant, whichalso includes corn, coal, ethanol, and distillers’ grains storage and handlingfacilities. Located on these 216 acres is an approximately 7,320 square footbuilding that serves as our headquarters. Our address is 91246 390th Avenue, Heron Lake, Minnesota56137-3175.

 

We also own elevator and grain storage facilities inLakefield, Minnesota and Wilder, Minnesota. The elevator and grain storagefacilities at each location have grain handling equipment and both upright andflat storage capacity. The storage capacity of the Lakefield, Minnesotafacility is approximately 1.9 million bushels and the storage capacity of theWilder, Minnesota facility is approximately 900,000 bushels.

 

All of our real property is subject to mortgages infavor of AgStar as security for loan obligations.

 

**ITEM3.****                                                                            ****LEGAL PROCEEDINGS**

 

On September 28,2005, HLBE executed a Design-Build Agreement with Fagen, Inc. by whichFagen, Inc. agreed to design and build a 50 million gallon per yearcoal-fired ethanol plant in Heron Lake, Minnesota, for a contract price ofapproximately $76,000,000.  The agreementcontained numerous warranty and guarantee provisions as well as a liquidateddamages provision.  Construction began inlate 2005, and after several delays the first corn grind took place on September 21,2007.  The plant, however, has not beenable to meet the air emissions warranties or operate as a “synthetic minorsource” as warranted and intended under the design-build agreement.

 

By the terms of theDesign-Build Agreement, claims or controversies between HLBE and Fagen, Inc.arising out of or relating to the Design-Build Agreement, or the breachthereof, are ultimately to be decided by Arbitration in accordance with theConstruction Industry Arbitration Rules of the American ArbitrationAssociation.  On September 18, 2009HLBE served and filed its Demand for Arbitration and Request forMediation.  A Revised Demand forArbitration was served and filed on December 23, 2009 following anunsuccessful attempt to mediate the dispute. In these Demands for Arbitration, HLBE alleges that Fagen, Inc. breachedthe terms and conditions of the Design-Build Agreement including its warrantiesand guarantees, was negligent in its efforts to correct various performance andemissions problems, had not completed the plant on a timely basis in accordancewith the Design-Build Agreement, and prior to the execution of the Agreementhad made certain negligent misrepresentations with respect to coal-firedethanol plants.  In the Demand forArbitration, HLBE seeks damages for breach of contract and breach of thewarranties and guarantees, damages resulting from the negligent efforts tocorrect the problems, damages for the negligent misrepresentations, as well asliquidated damages for delays in the plant construction.  HLBE seeks damages in the amount of$22,800,000.

 

Fagen, Inc.responded to the Demand for Arbitration by denying liability and assertingvarious affirmative defenses.  Inaddition, Fagen, Inc. brought a Counterclaim alleging that it is entitledto payment of a retainage held by HLBE in the amount of approximately $3.8million.  In addition, Fagen, Inc.alleges that it performed additional work and provided additional labor andmaterials to the plant in the amount of approximately $2.2 million; it allegesthat this did not constitute warranty or guarantee work and therefore it claimsit is entitled to payment of this additional amount.  HLBE responded to the Counterclaim by denyingthe allegations and asserting various affirmative defenses.  On January 4, 2010, Fagen, Inc.requested to join ICM, Inc. as a party to the arbitration action, claimingthat joinder was necessary for proper resolution of the claims and defenses inthe arbitration action.  On January 27,2010, ICM, Inc. responded to the request, agreeing to be joined providedcertain procedures are established.  Inits response, ICM also indicated that it intends to assert claims against usunder the license agreement we entered into with ICM as part of the designbuild agreement with Fagen.  On January 27,2010, we filed our response and objections to Fagen’s request to join ICM as aparty, and requested that a special arbitrator be appointed to resolve thejoinder issues.  We intend to defendagainst the Fagen counterclaims and any claims brought by ICM, Inc. andassert our defenses vigorously.

 

The arbitrationproceeding is in its early phase, and arbitrators have not yet been selected.

 

**ITEM4.**                                                                             **SUBMISSION OF MATTERS TOA VOTE OF SECURITY HOLDERS**

 

None.

 

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**PART II**

 

**ITEM5.                     MARKETFOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES**

 

**Market Information**

 

Although matching services may be available to helpmatch buyers and seller of our units, there is no established public tradingmarket for the units and we do not expect one to develop in the foreseeablefuture. To maintain our partnership tax status, we do not intend to list theunits on any stock exchange or over-the-counter securities market such as theOTC Bulletin Board.

 

 **Holders of Record**

 

As of January 1, 2010, there were 27,104,625 Class Aunits outstanding and held of record by 1,098 persons. There are no otherclasses of units outstanding.  As of January 1,2010, there were no outstanding options or warrants to purchase, or securitiesconvertible into, our units.

 

**Distributions**

 

We have never declared distributions. Our agreementswith lenders currently materially limit our ability to make distributions toour members and these agreements are likely to limit materially the futurepayment of distributions. For a further description of these restrictions,please see “Item 7 Management’s Discussion and Analysis of Financial Conditionand Results of Operations” and Note 9 of the notes to our audited consolidatedfinancial statements. In September 2007, we began operation of our ethanolplant and began generating revenue. If our financial performance and loancovenants permit, we expect to make cash distributions at times and in amountsthat will permit our members to make income tax payments. If our financialperformance and loan covenants further permit, we intend to make distributionsin excess of those amounts. Cash distributions are not assured, however, and wemay never be in a position to make distributions.

 

Under Minnesota law, we cannot make a distribution toa member if, after the distribution, we would not be able to pay our debts asthey become due or our liabilities, excluding liabilities to our members onaccount of their capital contributions, would exceed our assets.

 

**Securities Authorized for Issuanceunder Equity Compensation Plans**

 

There are no “compensation plans” (includingindividual compensation arrangements) under which any of our equity securitiesare authorized for issuance.

 

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**ITEM6.****                                                                            ****SELECTED FINANCIAL DATA**

 

**Selected Consolidated Financial Data**

 

The following table presents selected consolidatedfinancial and operating data as of the dates and for the periods indicated. Theselected financial data for October 31, 2009, 2008 and 2007 has beenderived from the audited consolidated financial statements included elsewherein this Annual Report on Form 10-K.

 

This selected consolidated financial data should beread in conjunction with “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” within Item 7 and the consolidatedfinancial statements and the accompanying notes included elsewhere in thisAnnual Report on Form 10-K. Among other things, those financial statementsinclude more detailed information regarding the basis of presentation for thefollowing consolidated financial data.

 
| ** **                                           | ** ** | **Fiscal Year Ended** | ** **  |
|------------------------------------------------------|------------|---------------------------------|-------------|
| ** **                                           | ** ** | **October 31,  2009**      | ** **  | **October 31,  2008** | ** ** | **October 31,  2007** | ** ** |
|                                                 |       |                            |        |   |   |   |   |
| **Statement  of Operations Data:**                   |       |                            |        |   |   |   |   |
| Revenues                                             |       | $                               | 88,304,596  |   | $ | 131,070,642 |   | $ | 23,560,498 |   |
| Cost of goods sold                                   |       | 90,857,247                      |        | 114,411,541 |   | 24,313,695 |   |
| Gross profit (loss)                                  |       | (2,552,651                      | )           | 16,659,101 |   | (753,197 | ) |
| Operating expenses                                   |       | 4,515,476                       |        | 3,351,252 |   | 3,527,199 |   |
| Operating income (loss)                              |       | (7,068,127                      | )           | 13,307,849 |   | (4,280,396 | ) |
| Other income (expense)                               |       | (4,261,307                      | )           | (4,689,810 | ) | (1,167,890 | ) |
| Net income (loss)                                    |       | $                               | (11,329,434 | ) | $ | 8,618,039 |   | $ | (5,448,286 | ) |
|                                                 |       |                            |        |   |   |   |   |
| Weighted average units  outstanding                  |       | 27,104,625                      |        | 27,104,625 |   | 26,361,406 |   |
|                                                 |       |                            |        |   |   |   |   |
| Net income (loss) per  unit — Basic and diluted |       | $                               | (0.42       | ) | $ | 0.32 |   | $ | (0.21 | ) |

 
| ** **                                  | ** ** | **As of**             | ** **  |                       |       |
|---------------------------------------------|------------|----------------------------|-------------|----------------------------|------------|
| ** **                                  | ** ** | **October 31,  2009** | ** **  | **October 31,  2008** | ** ** |   |   |
|                                        |       |                       |        |                       |       |   |   |
| **Balance  Sheet Data:**                    |       |                       |        |                       |       |   |   |
| Assets:                                     |       |                       |        |                       |       |   |   |
| Current assets                              |       | $                          | 12,926,672  |                       | $          | 27,223,185 |   |   |   |
| Property and equipment                      |       | 98,560,605                 |        | 103,882,039                |       |   |   |
| Other assets                                |       | 1,602,000                  |        | 2,295,586                  |       |   |   |
| Total assets                                |       | $                          | 113,089,277 |                       | $          | 133,400,810 |   |   |   |
|                                        |       |                       |        |                       |       |   |   |
| Current liabilities                         |       | $                          | 69,059,726  |                       | $          | 23,552,096 |   |   |   |
| Long-term debt                              |       | 4,775,804                  |        | 59,265,534                 |       |   |   |
| Members’ equity                        |       | 39,253,747                 |        | 50,583,180                 |       |   |   |
| Total liabilities and  members’ equity |       | $                          | 113,089,277 |                       | $          | 133,400,810 |   |   |   |

 

 

**ITEM7.                     MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

*The following discussion should beread in conjunction with our financial statements and related notes containedelsewhere in this Annual Report on Form 10-K. This discussion may containforward-looking statements based upon current expectations that involve risksand uncertainties. Our actual results and the timing of selected events coulddiffer materially from those anticipated in these forward-looking statements asa result of selected factors, including those set forth under “Risk Factors” inPart I, Item 1A of this Form 10-K. All forward-lookingstatements included herein are based on information available to us as of thedate hereof, and we undertake no obligation to update any such forward-lookingstatements.*

 

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We prepared the followingdiscussion and analysis to help readers better understand our financialcondition, changes in our financial condition, and results of operations forthe fiscal year ended October 31, 2009. Since our plant became operationalin September 2007, the financial data derived from our operations andrelated production and sales data for the twelve months ended October 31,2007 is not comparable to that of fiscal year ended October 31, 2009 or2008.

 

**Overview**

 

Heron Lake BioEnergy, LLCis a Minnesota limited liability company that was formed April 12, 2001under the name “Generation II, LLC”. In June 2004, we changed our name toHeron Lake BioEnergy, LLC. We were formed for the purpose of constructing andoperating a dry mill corn-based ethanol plant near Heron Lake, Minnesota. Theplant has a stated capacity to produce 50 million gallons of denaturedfuel grade ethanol and 160,000 tons of dried distillers’ grains per year.Production of ethanol and distillers’ grains at the plant began, in September 2007.We began recording revenue from plant production in October 2007, the lastmonth of our fiscal year. Our revenues are derived from the sale and distributionof our ethanol throughout the continental United States and in the sale anddistribution of our distillers’ grains locally, and throughout the continentalUnited States.

 

Our operating results arelargely driven by the prices at which we sell ethanol and distillers grains andthe costs related to their production, particularly the cost of corn.Historically, the price of ethanol tended to fluctuate in the same direction asthe price of unleaded gasoline and other petroleum products. However, duringfiscal 2008 and continuing into fiscal 2009, it appears ethanol prices tendedto move up and down proportionately, with changes in corn prices. The price ofethanol can also be influenced by factors such as general economic conditions,concerns over blending capacities, and government policies and programs. Theprice of distillers grains is generally influenced by supply and demand, theprice of substitute livestock feed, such as corn and soybean meal, and otheranimal feed proteins. Our largest component of and cost of production is corn.The cost of corn is affected primarily by factors over which we lack anycontrol such as crop production, carryout, exports, government policies andprograms, and weather. The growth of the ethanol industry has increased thedemand for corn. We believe that continuing increase in global demand willresult in corn prices above historic averages.   As an example of ourpotential sensitivity to price changes, if the price of ethanol rises or falls$.10 per gallon, our revenues may increase or decrease accordingly byapproximately $5.0 million, assuming no other changes in our business.Additionally, if the price of corn rises or falls $0.25 per bushel, our cost ofgoods sold may increase or decrease by $5.0 million, again assuming noother changes in our business. During our fiscal 2009, the market price ofethanol and corn were extremely volatile. The price of corn hit a high of $4.73per bushel in June, 2009 and a low of $3.06 in September, 2009 while the priceof ethanol fluctuated from a high of $2.20 in October, 2009 and a low of $1.50in July, 2009.

 

**Trends and Uncertainties ImpactingOur Operations**

 

Our current and futureresults of operation are affected and will continue to be affected by factorssuch as (a) volatile and uncertain pricing of ethanol and corn; (b) availabilityof corn that is, in turn, affected by trends such as corn acreage, weatherconditions, and yields on existing and new acreage diverted from other crops;and (c) the supply and demand for ethanol, which is affected by acceptanceof ethanol as a substitute for fuel, public perception of the ethanol industry,government incentives and regulation, and competition from new and existingconstruction, among other things. Other factors that may affect our futureresults of operation include those factors discussed in “Item 1. Business” and “Item1A. Risk Factors.”

 

**Critical Accounting Estimates**

 

We review long-livedassets and estimates related to inventory and forward purchase commitments forimpairment whenever events or changes in circumstances indicate that therelated carrying amounts may not be recoverable. Impairment testing for assetsrequires various estimates and assumptions, including an allocation of cashflows to those assets and, if required, an estimate of the fair value of thoseassets. Our estimates are based upon assumptions believed to be reasonable, butwhich are inherently uncertain and unpredictable. These valuations require theuse of management’s assumptions, which do not reflect unanticipated events andcircumstances that may occur. In our analysis, we consider future corn costsand ethanol prices, break-even points for our plant and our risk managementstrategies in place through our derivative instruments and forward contracts.Given the significant assumptions required and the possibility that actualconditions will differ, we consider the assessment of impairment of ourlong-lived assets to be a critical accounting estimate.

 

We reviewed ourlong-lived assets for impairment at October 31, 2009. As a result of thisreview and our related analysis, we believe our long-lived assets were notimpaired as of October 31, 2009.

 

We enter forwardcontracts for corn purchases to supply the plant.  These contractsrepresent firm purchase commitments which along with inventory on hand must beevaluated for potential losses.  We have estimated a loss on these firmpurchase commitments to corn contracts in place and for corn on hand at October 31,2009 where the price of corn exceeds the market price and upon being used inthe manufacturing process and eventual sale of products we anticipatelosses.  Our estimates include various assumptions including the futureprices of ethanol, distillers grains and corn.

 

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**Fiscal Year Ended October 31,2009 Compared to Fiscal Year Ended October 31, 2008**

 

The following table showsthe results of our operations and the percentage of revenues, cost of goodssold, operating expenses and other items to total revenues in our statements ofoperations for the fiscal year ended October 31, 2009 and 2008:

 
| ** **                                     | ** ** | **2009**   | ** **  | **2008** | ** ** |
|------------------------------------------------|------------|------------|-------------|----------|------------|
| **Income Statement Data**                      | ** ** | **Amount** | ** **  | **%**    | ** ** | **Amount** | ** ** | **%** | ** ** |
| Revenues                                       |       | $          | 88,304,596  |     | 100.0      |   | $ | 131,070,642 |   | 100.0 |   |
|                                           |       |       |        |     |       |   |   |   |   |
| Cost of Goods  Sold                            |       | 90,857,247 |        | 102.9    |       | 114,411,541 |   | 87.3 |   |
|                                           |       |       |        |     |       |   |   |   |   |
| Gross Margin                                   |       | (2,552,651 | )           | (2.9     | )          | 16,659,101 |   | 12.7 |   |
|                                           |       |       |        |     |       |   |   |   |   |
| Selling,  General, and Administrative Expenses |       | 4,515,476  |        | 5.1      |       | 3,351,252 |   | 2.5 |   |
|                                           |       |       |        |     |       |   |   |   |   |
| Operating Income  (Loss)                       |       | (7,068,127 | )           | (8.0     | )          | 13,307,849 |   | 10.2 |   |
|                                           |       |       |        |     |       |   |   |   |   |
| Other Expense                                  |       | (4,261,307 | )           | (4.8     | )          | (4,689,810 | ) | (3.6 | ) |
|                                           |       |       |        |     |       |   |   |   |   |
| Net Income  (Loss)                             |       | $          | (11,329,434 | )        | (12.8      | ) | $ | 8,618,039 |   | 6.6 |   |

 

*Revenues*

 

Ethanol revenues duringthe period ended October 31, 2009 were approximately $70.4 million,comprising 80% of our revenues. Sales of ethanol through September 30,2009 were made pursuant to the terms of our ethanol marketing agreement withRPMG, Inc. under which our ethanol was pooled with the ethanol of otherethanol producers whose ethanol was marketed by RPMG.  We paid RPMG amarketing fee and RPMG paid us a netback price per gallon that is based uponthe difference between the pooled average delivered ethanol selling price andthe pooled average distribution expense.  These averages werecalculated based upon each pool participant’s selling price and expenseaveraged in direct proportion to the volume of ethanol supplied by eachparticipant to the pool.

 

We believe that theethanol market structure has changed since we entered into our ethanolmarketing agreement with RPMG, and in particular during the past one to twoyears.  We determined, in light of those changes, that the poolmarketing arrangement used by RPMG was no longer an effective arrangement underthe current market structure and circumstances. We accordingly notified RPMGthat the ethanol marketing agreement would be terminated effective September 30,2009.

 

Sales of ethanolsubsequent to September 30, 2009 were made pursuant to the terms of ourethanol marketing agreement with C&N Ethanol Marketing Corporation (“C&N”).  Under the Agreement, C&N purchases,markets and re-sells all of the ethanol produced at the Company’s plant for thethree year term of the Agreement.  C&N will pay us the gross salesprice to the customer less expenses and a 1% marketing fee after expenses.

 

For the year ended October 31,2009, we sold approximately 46.4 million gallons of ethanol at an average priceof $1.52 per gallon. For the year ended October 31, 2008, we soldapproximately 48.4 million gallons of ethanol at an average price of $2.10 pergallon.  We believe that the number ofgallons of ethanol sold was affected by the plant’s productivity that wasimpacted by scheduled and unscheduled downtime during the year, including as aresult of testing and process changes relating to our air emissions. Further,the price of ethanol during our fiscal year was affected by the demand forethanol as a motor fuel which is affected by, among other factors, regulatorydevelopments, gasoline consumption, and the price of crude oil.  Gasolineconsumption was volatile during the fiscal year as the price for crude oilfluctuated radically.  The price was also affected by federal RFS blendingmandates.

 

We may hedge anticipatedethanol sales through a variety of mechanisms. Our marketers, whether RPMG orC&N, are obligated to use reasonable efforts to obtain the best price forour ethanol. To mitigate ethanol price risk and to obtain the best margins onethanol that is marketed and sold by a marketer, we may utilize ethanol swaps,over-the-counter (“OTC”) ethanol swaps, or OTC ethanol options that aretypically settled in cash, rather than gallons of the ethanol we produce. For the years ended October, 31, 2009 and 2008, we recorded gains of $0.4million and $3.6 million respectively related to ethanol derivativeinstruments.  There are timing differences in the recognition of gains onderivatives as compared to the corresponding sale of ethanol.  As such,the gains recognized could be associated with related sales in fiscal years2007, 2008 or 2009.

 

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We expect to seefluctuations in ethanol prices over the next fiscal year. While the demand forethanol is expected to continue since gasoline blenders will need increasingamounts of ethanol to meet the Renewable Fuels Standard’s blendingrequirements, the supply is also expected to increase as additional productionfacilities are completed or return to production. In addition, low prices forpetroleum and gasoline will exert downward pressure on ethanol prices. Ifethanol prices decline, our earnings will also decline, particularly if cornprices remain substantially higher than historic averages, as they were in ourfiscal year 2009.  Future prices for fuelethanol will be affected by a variety of factors beyond our control including,the demand for ethanol as a motor fuel, federal incentives for ethanolproduction, the amount and timing of additional domestic ethanol production andethanol imports and petroleum and gasoline prices.

 

Total sales of DGS duringfiscal years 2009 and 2008 equaled approximately $12.8 million and$18.2 million, respectively, comprising 14% of our revenues for each year.Under a marketing agreement with CHS, Inc., CHS markets and sells alldistillers’ grains produced by our ethanol plant. Under the terms of theagreement, we receive a price equal to the selling price, less a charge of 2%or 4% of the price for distillers’ grains and a fee of $2.00 per ton ofsolubles, less the cost of delivering the product to the customer.  In fiscal year 2009 we sold approximately 119,000 tons of dried distillers’grain compared to 113,000 tons sold in fiscal year 2008.  The average price we received for distillers’grain was approximately $107 per ton in fiscal year 2009 and approximately $147per ton in fiscal year 2008.

 

The prices for DGSincreased significantly during the first three quarters of fiscal 2008, due tothe rising price of corn, soybean meal, and other animal feed proteins that aresubstitutes for DGS.  These factors werenot present in fiscal year 2009. However, during the last quarter of fiscal 2008, decreasing corn pricesplaced downward pressure on DGS prices which continued through fiscal 2009. Inaddition, the average price we received for our DGS in fiscal 2008 was limitedby forward wet distillers grains contracts locking in a portion of our DGSprices.

 

Prices for distillers’grains are affected by a number of factors beyond our control such as thesupply of and demand for distillers’ grains as an animal feed and prices forcompeting feeds. We believe that current market prices for distillers’ grainsare approaching levels that can be sustained long-term as long as the prices ofcompeting animal feeds remain steady or increase, livestock feeders continue tocreate demand for alternative feed sources such as distillers’ grains and thesupply of distillers’ grains remains relatively stable. On the other hand, ifcompeting commodityprice values retreat and distillers’ supplies increase due to growth in theethanol industry, distillers’ grains prices may decline.

 

*Cost of Goods Sold*

 

Our costs of salesinclude, among other things, the cost of corn used in ethanol and DGSproduction (which is the largest component of costs of sales), coal, processingingredients, electricity, and wages, salaries and benefits of productionpersonnel. We use approximately 1.5 million bushels of corn per month atthe plant. We contract with local farmers and elevators for our corn supply. Weare able to store corn that we purchase in our elevators in Lakefield andWilder, Minnesota, as well as in on-site storage at the plant.

 

Our costs of sales(including lower of cost or market adjustments) as a percentage of revenueswere 102.9% and 87.3% for the twelve months ended October 31, 2009 and,2008, respectively.  The per bushel costof corn purchased (net of losses realized in fiscal year 2008 for bushelsdelivered in fiscal 2009) decreased approximately 19% in the twelve monthsended October 31, 2009 as compared to the twelve months ended October 31,2008.  Cost of goods sold includes lowerof cost or market adjustments of $5.4 million for the fiscal year ended October 31,2009, which related to forward purchase contracts and inventory where the fixedprice was more than the estimated realizable value. The lower of cost or marketadjustment for the twelve months ended October 31, 2008 was $8.7million   We had gains related to cornderivative instruments of approximately $1.2 million and $6.3 million for thetwelve months ended October 31, 2009 and 2008, respectively, which reducedcost of sales.  In summary, lower of costor market adjustments decreased $3.3 million for the fiscal year ended October 31,2009 as compared to the fiscal year ended October 31, 2008.  During the same periods, gains on derivativesdecreased $5.1 million.  These increasednet costs  combine with the 28% decreasein the per gallon sales price of ethanol caused the increase in the cost ofgoods sold as a percent of revenues for the twelve months ended October 31,2009**.** Our gross margin (loss) for the twelve monthsended October 31, 2009 decreased to (2.9%) from 12.7% for the twelvemonths ended October 31, 2008. We had a negative gross margin in fiscalyear 2009 as compared to positive gross margin in fiscal year 2008 due to thedecline in ethanol prices; increased costs of goods sold, relative to revenues,due to losses on forward contracts; and decreased gains on derivativeinstruments. In addition, lower production levels and fixed costs contributedto the negative gross margin incurred.

 

The cost of cornfluctuates based on supply and demand, which, in turn, is affected by a numberof factors that are beyond our control. We expect our gross margin to fluctuatein the future based on the relative prices of corn and fuel ethanol. We usefutures and options contracts to minimize our exposure to movements in cornprices, but there is no assurance that these hedging strategies will beeffective.  Through October 31,2009, none of our derivative contracts were designated as hedges and, as aresult, changes to the market value of these contracts were recognized as anincrease or decrease to our costs of goods sold. As a result, gains or losseson derivative instruments do not necessarily coincide with the related cornpurchases. This may cause fluctuations in cost of goods sold. While we do not usehedge accounting to match gains or losses on derivative instruments, we believethe derivative instruments provide an economic hedge.

 

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Costs of sales alsoinclude expenses directly attributable to the repair and maintenance of theplant.  During the three months ended July 31,2009, we incurred costs of approximately $300,000 as part of a five day plannedannual shutdown and maintenance procedure. Upon shutdown, portions of the refractory section of the boilercollapsed.  While there were no injuriessustained, significant additional costs were incurred to secure the refractory,ensure the safety of the workers completing repairs and to complete therepairs.  This added eleven days to theshutdown for a total of sixteen days shutdown during May.

 

During the three monthsended July 31, 2009, we entered into an amendment to our agreement with aleasing company under which we lease certain rail cars.  The terms of the amendment reduce the railcars under lease by 50 cars and increase the monthly rental amount perremaining rail car until July 1, 2014.  This will result in a monthly cash savings of $425 per rail car or$21,250.

 

We have forward contractsin place for corn purchases of approximately 1.8 million bushel through May 2010which represents approximately 9% of our anticipated purchases in fiscal2010.  Currently, some of these corncontract prices are above the current market price for corn.  Upon taking delivery under these contracts,we would incur a loss.  Accordingly, werecorded a loss on these purchase commitments of approximately $5.0 million forthe twelve months ended October 31, 2009. Of the amount recorded in costs of goods sold, we have realized $3.8million upon delivery and may realize the remaining $1.2 million in fiscal2010.  The loss, along with a write downof inventory on hand of $0.4 million, was recorded as a lower of cost or marketadjustment on the statement of operations.  The amount of the loss wasdetermined by applying a methodology similar to that used in the lower of costor market evaluation with respect to inventory.  Given the uncertainty offuture ethanol prices, this loss may or may not be recovered, and furtherlosses on the outstanding purchase commitments could be recorded in futureperiods.  At October 31, 2009, 1.2 million bushel subject to futurecontracted prices had contracted prices less than current market prices.  Unrealized gains on these contracts have notbeen recorded. In order to mitigate risk associated with price fluctuations ofcoal, the Company has entered into coal supply agreements with a minimumcommitment of approximately $4,950,000 per year until May 2012, includingtransportation, with provisions for fuel surcharges and adjustments forinflation.

 

*Selling, General, and AdministrativeExpense*

 

Operating expensesinclude wages, salaries and benefits of administrative employees at the plant,insurance, professional fees and similar costs and generally do not vary withthe level of production at the plant. These expenses were $4.5 million for the twelve months ended October 31,2009 up 34.7% from $3.3 million for the twelve months ended October 31,2008.  Upon a planned annual shutdown,portions of the refractory section of the boiler collapsed.  While there were no injuries sustained,significant additional costs were incurred to secure the refractory, ensure thesafety of the workers completing repairs and to complete the repairs.  Costs associated with the unplanned repairswere approximately $700,000 and are included in operating expenses.  Professional fees increased for the twelvemonths ended October 31, 2009 as compared to the prior year period becauseof additional legal, accounting and internal control consulting work inanticipation of required compliance with the Sarbanes-Oxley Act of 2002 and SECreporting requirements, as well as the arbitration action we commenced againstFagen, Inc. Decreased revenue for the fiscal year ended October 31,2009 negatively affected operating expenses as a percentage of revenue as totalrevenues declined approximately 33%.

 

*Operating Income*

 

Our loss from operationsfor fiscal year 2009 totaled $7.1 million compared to income from operationsfor fiscal year 2008 of approximately $13.3 million.

 

*Other Income and (Expense)*

 

Other expense consistedprimarily of interest expense. Interest expense consists primarily of interestpayments on our credit facilities described below. Interest expense for fiscalyear 2009, which is down approximately 16.5% as compared to the twelve monthsended October 31, 2008, is dependent on the balances outstanding and oninterest rate fluctuations.  As of October 31,2009, debt balances were down slightly as compared to balances at October 31,2008.  The average 1 month LIBOR rate forthe twelve months ended October 31, 2009 was 0.52% compared to 3.25% forthe twelve months ended October 31, 2008. From May 1, 2009 through May 29, 2009, AgStar added a 2.0%surcharge to the interest rate on the outstanding amounts under the Company’smaster loan agreement.  Also included inother expense is the write-off of loan costs of approximately $445,000. Becausewe have not obtained a waiver from AgStar for actual or expected violations ofour master loan agreement, our long-term debt with AgStar was classified as acurrent liability. As such, we wrote-off the remaining loan costs rather thanamortizing them over the original contractual term of the loans.

 

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**Year Ended October 31, 2008Compared to Year Ended October 31, 2007**

 
| ** **                                     | ** ** | **2008**    | ** **  | **2007** | ** ** |
|------------------------------------------------|------------|-------------|-------------|----------|------------|
| **Income Statement Data**                      | ** ** | **Amount**  | ** **  | **%**    | ** ** | **Amount** | ** ** | **%** | ** ** |
| Revenues                                       |       | $           | 131,070,642 |     | 100.0      |   | $ | 23,560,498 |   | 100.0 |   |
|                                           |       |        |        |     |       |   |   |   |   |
| Cost of Goods  Sold                            |       | 114,411,541 |        | 87.3     |       | 24,313,695 |   | 103.2 |   |
|                                           |       |        |        |     |       |   |   |   |   |
| Gross Margin                                   |       | 16,659,101  |        | 12.7     |       | (753,197 | ) | (3.2 | ) |
|                                           |       |        |        |     |       |   |   |   |   |
| Selling,  General, and Administrative Expenses |       | 3,351,252   |        | 2.5      |       | 3,527, 199 |   | 15.0 |   |
|                                           |       |        |        |     |       |   |   |   |   |
| Operating Income  (Loss)                       |       | 13,307,849  |        | 10.2     |       | (4,280,396 | ) | (18.2 | ) |
|                                           |       |        |        |     |       |   |   |   |   |
| Other Expense                                  |       | (4,689,810  | )           | (3.6     | )          | (1,167,890 | ) | (4.9 | ) |
|                                           |       |        |        |     |       |   |   |   |   |
| Net Income  (Loss)                             |       | $           | 8,618,039   |     | 6.6        |   | (5,448,286 | ) | (23.1 | ) |
|                                                |            |             |             |          |            |  |  |  |  |  |  |

 

*Revenues*

 

As previously noted,commercial production of fuel ethanol and distillers’ grains began in September 2007.Accordingly, our first full year of revenues from the sale of fuel ethanol anddistillers’ grains with solubles (“DGS”) produced at the plant occurred duringthe fiscal year ended October 31, 2008. Ethanol revenues during the periodended October 31, 2008 were approximately $101.8 million, comprising78% of our revenues. All sales of ethanol were made pursuant to the terms ofour ethanol marketing agreement with RPMG, Inc. Under the agreement, RPMGmust use its best efforts to market all ethanol produced by our ethanol plantpursuant to a pooled marketing arrangement. We receive a price equal to theactual pooled price received by RPMG, less the expense of distribution and amarketing fee charged per gallon of ethanol sold. For the year ended October 31,2008, we sold approximately 48.4 million gallons of ethanol at an average priceof $2.10 per gallon. For the 2008 fiscal year, we believe that the number ofgallons of ethanol sold were affected by the plant’s productivity that wasimpacted by scheduled and unscheduled downtime during the year, including as aresult of testing and process changes relating to our air emissions. Further,the price of ethanol during our fiscal year was affected by the demand forethanol as a motor fuel which is affected by, among other factors, regulatorydevelopments, gasoline consumption, and the price of crude oil.  Gasolineconsumption was volatile during the fiscal year as the price for crude oilfluctuated radically.  The price was also affected by federal RFS blendingmandates.

 

We may hedge anticipatedethanol sales through a variety of mechanisms. We market all of our ethanolthrough RPMG, Inc., which is obligated to use reasonable efforts to obtainthe best price for our ethanol. To mitigate ethanol price risk and to obtainthe best margins on ethanol that is marketed and sold by RPMG, we may utilizeethanol swaps, over-the-counter (“OTC”) ethanol swaps, or OTC ethanol optionsthat are typically settled in cash, rather than gallons of the ethanol weproduce.  For the year ended October, 31, 2008, we recorded gains of $3.6million related to derivative instruments.  There are timing differencesin the recognition of gains on derivatives as compared to the correspondingsale of ethanol.  As such, the gains recognized could be associated withrelated sales in fiscal years 2007, 2008 or 2009.

 

Ethanol prices reached$2.95 per gallon in July 2008, but have declined substantially since thattime.   Lower ethanol prices continued into the first quarter offiscal 2009, and we expect to see continuing fluctuations in ethanol pricesover the next fiscal year. While the demand for ethanol is expected to continuesince gasoline blenders will need increasing amounts of ethanol to meet theRenewable Fuels Standard’s blending requirements, the supply is also expectedto increase as additional production facilities are completed. In addition, lowprices for petroleum and gasoline will exert downward pressure on ethanolprices. If ethanol prices decline, our earnings will also decline, particularlyif corn prices remain substantially higher than historic averages.

 

Future prices for fuelethanol will be affected by a variety of factors beyond our control including,the demand for ethanol as a motor fuel, federal incentives for ethanolproduction, the amount and timing of additional domestic ethanol production andethanol imports and petroleum and gasoline prices.

 

Total sales of DGS duringfiscal year 2008 equaled approximately $18.2 million, comprising 14% ofour revenues. Under a marketing agreement with CHS, Inc., CHS markets andsells all distillers’ grains produced by our ethanol plant. Under the terms ofthe agreement, we receive a price equal to the selling price, less a charge of2% or 4% of the price for distillers’ grains and a fee of $2.00 per ton ofsolubles, less the cost of delivering the product to the customer.  In fiscal year 2008 we sold approximately 113,000 tons of dried distillers’grains at an

 

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average price of approximately $147 per ton. In fiscalyear 2008 we sold approximately 32,000 tons of modified wet distillers’ grainsat an average price of approximately $48 per ton.

 

Similarly, the prices forDGS increased significantly during the first three quarters of fiscal 2008, dueto the rising price of corn, soybean meal, and other animal feed proteins thatare substitutes for DGS. However, during the last quarter of fiscal 2008,decreasing corn prices placed downward pressure on DGS prices. In addition, theaverage price we received for our DGS in fiscal 2008 was limited by forward wetdistillers grains contracts locking in a portion of our DGS prices.

 

Prices for distillers’grains are affected by a number of factors beyond our control such as thesupply of and demand for distillers’ grains as an animal feed and prices forcompeting feeds. We believe that current market prices for distillers’ grainsare approaching levels that can be sustained long-term as long as the prices ofcompeting animal feeds remain steady or increase, livestock feeders continue tocreate demand for alternative feed sources such as distillers’ grains and thesupply of distillers’ grains remains relatively stable. On the other hand, ifcompeting commodity price values retreat and distillers’ supplies increase dueto growth in the ethanol industry, distillers’ grains prices may decline.

 

*Cost of Goods Sold*

 

Cost of goods sold duringthe year ended October 31, 2008 was $114,411,541 million,representing 87% of total revenues. Cost of goods sold consists primarily ofthe costs of corn, coal, depreciation, electricity and denaturant.  We useapproximately 1.5 million bushels of corn and 8,000 tons of coal per monthat our ethanol plant. We contract with local farmers and elevators for our cornsupply and secure coal under our agreement with Northern Coal TransportCompany.  Corn prices on the Chicago Board of Trade reached $7.60 perbushel during mid-summer of 2008. Prices declined significantly since thattime, but the average price paid for corn during the fiscal year ended October 31,2008 was $4.78 per bushel

 

The cost of both corn andcoal fluctuates based on supply and demand which, in turn, is affected by anumber of factors which are beyond our control. We expect our gross margin tofluctuate in the future based on the relative prices of corn, coal and fuelethanol. We use futures and options contracts to minimize our exposure tomovements in corn prices, but there is no assurance that these hedgingstrategies will be effective. At October 31, 2008, none of our derivativecontracts were designated as hedges and, as a result, changes to the marketvalues of these contracts are recognized as an increase or decrease to ourcosts of goods sold. For the year ended October 31, 2008, we recognized again of approximately $6.3 million with respect to these contracts, whichdecreased costs of goods sold during the period by this amount.

 

The Company had forwardcontracts in place for corn purchases of approximately $31,663,000 through October 2009,which represents approximately 38% of the Company’s anticipated purchases infiscal 2009. Some of these corn contract prices were above current marketprices for corn.  Given the recent declining price of corn and ethanol,upon taking delivery under these contracts, the Company would incur aloss.  Accordingly, the Company recorded a loss on these purchasecommitments of approximately $7,123,000 at October 31, 2008.  Theloss, along with a write down of inventory on hand of $1,628,000, was recordedas a lower of cost or market adjustment on the statement of operations. The amount of the loss was determined by applying a methodology similar to thatused in the lower of cost or market evaluation with respect to inventory. Based on the positions at October 31, 2008, further adverse price changesof 10% in the price of ethanol and corn subsequent to year-end would result inadditional losses of approximately $1,254,000.

 

In order to mitigate riskassociated with price fluctuations of coal, The Company has entered into coalsupply agreements with a minimum commitment of approximately $4,950,000 peryear until May 2012, including transportation, with provisions for fuelsurcharges and adjustments for inflation.

 

*Selling, General, and AdministrativeExpense*

 

Selling, general andadministrative expenses include wages, salaries and benefits of administrativeemployees at the plant, insurance, professional fees and similar costs. Theseexpenses decreased in fiscal year 2008 as compared to fiscal year 2007 byapproximately $192,000 to $3.3 million or 2.5% of total revenues.  Thedecrease is due, in part, to increased expenses in fiscal year 2007 resultingfrom the delayed production start date.

 

*Operating Income*

 

Our income fromoperations for fiscal year 2008 totaled approximately $13.3 million,compared to an operating loss of approximately $4.3 million for fiscal year2007. This change was a result of our transition from a development stagecompany to an operational company.

 

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*Other Income and (Expense)*

 

Other income and expenseconsists primarily of interest expense of approximately $4.81 million. Interestexpense consists primarily of interest payments under our agreements with AgStar).Also included in other income and expense were interest income and other incometotaling approximately $118,000.

 

**Liquidity and Capital Resources**

 

As of October 31,2009, we had cash and cash equivalents (other than restricted cash) ofapproximately $3.2 million, current assets of approximately $12.9 million andtotal assets of approximately $113.1 million.

 

Our principal sources ofliquidity consist of cash provided by operations, cash and cash equivalents onhand, and available borrowings under our master loan agreement with AgStar.Under the master loan agreement, we have three forms of debt: a term note, arevolving term note and a line of credit. The total indebtedness to AgStar at October 31, 2009 consists of$53.4 million under the term note, $1.1 million under the revolving term noteand $5.0 million under the line of credit. Among other provisions, our master loan agreement contains covenantsrequiring us to maintain various financial ratios and tangible net worth. Italso limits our annual capital expenditures and membership distributions. Allof our assets and real property are subject to security interests and mortgagesin favor of AgStar as security for the obligations of the master loanagreement.  As of October 31, 2009,we were in default of covenants of our master loan agreement with AgStarrequiring us to maintain at least $5.0 million minimum working capital; atleast $39.5 million of tangible net worth; and a fixed charge ratio of 1.20 to1.00 or greater.

 

In May 2008, welocked in an interest rate of 3.58% plus 3.00%, which totals 6.58%, on $45.0million of the term note, for three years ending April 30, 2011. Theremainder of the amounts outstanding on the term note is subject to thevariable rate based on the one-month LIBOR plus 3.25%.  We are required tomake equal monthly payments of principal and interest of approximately $640,000to amortize the note over a period not to exceed ten years, with a finalballoon payment due in October 2012. In addition, we are required to makeadditional payments on the term note of excess cash flow, as defined in theagreement, up to $2.0 million per year to the lending institution until we meetcertain minimum tangible owner’s equity, as defined in the agreement. As partof the debt financing, the premium above LIBOR may be reduced based on theratio of members’ equity to assets. AgStar implemented a 2.0% interest rate surcharge effective May 1,2009 through May 29, 2009, on the total debt outstanding in accordancewith the terms of the master loan agreement due to the defaults explainedbelow.

 

Our principal uses ofcash are to pay operating expenses of the plant and to make debt servicepayments on our long-term debt. During the twelve months ended October 31,2009, we used cash to make principal payments of approximately $5.0 millionagainst our long-term debt. During the same period, we drew $5.0 million on ourline of credit described below.

 

The following tablesummarizes our sources and uses of cash and equivalents from our condensedconsolidated statements of cash flows for the periods presented (in thousands):

 
| ** **                                           | ** ** | **Year Ended  October 31** | ** ** |
|------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                           | ** ** | **2009**                             | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net cash  provided by (used in) operating activities |       | $                                    | (8,334     | ) | $ | 23,193 |   | $ | (12,721 | ) |
| Net cash used in  investing activities               |       | (232                                 | )          | (1,436 | ) | (4,175 | ) |
| Net cash  provided by (used in) financing activities |       | 395                                  |       | (13,492 | ) | 17,362 |   |
| Net increase  (decrease) in cash and equivalents     |       | $                                    | (8,171     | ) | $ | 8,265 |   | $ | 466 |   |

 

*Year Ended October 31, 2009Compared to Year Ended October 31, 2008*

 

During the twelve monthsended October 31, 2009, we used $8.3 million in cash for operatingactivities. This use consists primarily of funding a net loss of $5.2 millionexclusive of depreciation and amortization of $6.1 million; and payments forcorn under deferred payment agreements and other payables of $3.2 million.

 

During the twelve monthsended October 31, 2009, we used approximately $232,000 for investingactivities to pay for capital expenditures and intangibles, and do notanticipate any significant capital expenditures during fiscal 2010.

 

During the twelve monthsended October 31, 2009, we generated $395,000 from financing activitiesconsisting primarily of advances on the line of credit of $5.0 million,payments on long term debt of approximately $5.0 million and the release ofrestricted cash in the amount of $0.4 million.

 

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At October 31, 2009, wewere in default of covenants of our master loan agreement with AgStar requiringus to maintain at least $5.0 million minimum working capital; at least $39.5million of tangible net worth; and a fixed charge ratio of 1.20 to 1.00 orgreater. Additionally, we do not expect to be in compliance with one or morecovenants of the master loan agreement as of fiscal year end 2010 unlessamendments are issued. Our failure to maintain the required amount of workingcapital constitutes an event of default under the master loan agreement, entitlingthe lender to accelerate and declare due all amounts outstanding under themaster loan agreement. Therefore, we have classified $49.3 million of theAgStar debt as a current liability that would otherwise be classified as longterm. As a result, current liabilities as of October 31, 2009 totaledapproximately $69.1 million, including $49.3 million of long-term debtreclassified as current liabilities.  Inconnection with the renewal of our revolving line of credit effective May 29,2009, AgStar waived the Company’s noncompliance with the working capitalcovenant of the master loan agreement as of and for the periods ending January 31,2009 and April 30, 2009.  On September 9,2009, AgStar waived the Company’s noncompliance with the working capital covenantof the master loan agreement for the period ended July 31, 2009.  Our debt with AgStar remains classified as acurrent liability based on current and projected violations of debt covenantswithin the next year.

 

Our line of credit underthe master loan agreement with AgStar renewed at a maximum commitment of$6,750,000.  Effective May 29, 2009,we entered into an Amendment No. 3 to the Fifth Supplement to our masterloan agreement, as previously amended and supplemented, with AgStar.  Among other things, the effect of thisamendment was to renew the Company’s revolving line of credit loan at a maximumcommitment of $6,750,000 and a maturity date of November 1, 2009.  Effective December 8, 2009, we enteredinto an Amendment No. 4 to the Fifth Supplement to our master loanagreement to extend the maturity date of the revolving line of credit to February 1,2010.  As of October 31, 2009, wehad drawn $5.0 million on the line of credit.

 

We are not currently incompliance with all covenants of the master loan agreement and there is noassurance that we will be able to comply in the future with all covenants andobligations of the master loan agreement or that any waiver or amendment to themaster loan agreement will be provided by AgStar.  Further, there can be no assurance thatAgStar will not demand immediate repayment of all $59.5 million in indebtednessoutstanding under the master loan agreement at October 31, 2009 orexercise any of its rights as a secured party with respect to the Company’sassets now or in the future should we fail to comply with any covenants in thefuture. We do not have adequate capital to repay all of the amounts that wouldbecome due if AgStar accelerates our obligations under the master loanagreement.  Further, we do not have adequate cash to repay the $5.0million outstanding on the line of credit at October 31, 2009 and intendto request an additional extension of the maturity date of this line of creditbeyond February 1, 2010.  There canbe no assurance that such an extension will be granted on terms advantageous tous, if at all.  Further, while an eventof default exists, the Company is not permitted to borrow additional fundsunder its line of credit or revolving term note unless AgStar consents to theadvance. While AgStar has consented to make advances in the past, our potentialinability to borrow additional funds under the master loan agreement may resultin a working capital shortfall.

 

The Company’s plan toaddress the expected shortfall of working capital is to conserve funds byutilizing and reducing corn inventory as well as reducing operating expensesthrough cost controls. The Company believes it has sufficient funding for itsbusiness in the short-term if it is not required to repay the outstandingindebtedness to AgStar or the outstanding indebtedness on the line of credit,based on converting and selling inventory, and reducing expenses. If thecurrent industry conditions continue and the Company is not able to maintainsufficient funding in the short-term, the Company may be forced to raisesubordinated debt, if available, sell additional equity, restructure orsignificantly curtail its operations, file for bankruptcy or cease operations.The financial statements do not include any adjustments relating to the recoverabilityand classification of recorded asset amounts or amounts and classification ofliabilities that might be necessary should the Company be forced to take anysuch actions.  However, there can be noassurance, that we will not require additional financing in the future or thatany additional financing will be available to us on satisfactory terms, if atall.

 

During fiscal 2008, wewere not in compliance with a covenant of our loan agreements with AgStarrequiring the submission of quarterly financial statements within 30 days ofthe end of each quarter. However, AgStar waived these events of non-compliancewith this covenant. Other than this covenant relating to delivery of financialstatements, we were in compliance with the covenants of our loan agreementswith AgStar during fiscal year 2008.

 

*Year Ended October 31, 2008Compared to Year Ended October 31, 2007*

 

Operating Activities — Wegenerated approximately $23 million from operating activities in fiscal year2008 compared to fiscal year 2007 during which we used approximately $13million for operating activities. This increase of approximately $36 millionwas due to a number of factors. Contributing to the net increase were thefollowing:

 

(1)                               Net income was $8.6 million for the yearended October 31, 2008 compared to a net loss of $5.4 million for yearended October 31, 2007.

 

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(2)                                 Depreciation and amortization expensefor the year ended October 31, 2008 as compared to the year ended October 31,2007 increased $ 4.4 million to $5.7 million.

 

(3)                                 As of October 31, 2007, we had usedcash to purchase inventory in the amount of $19 million compared to October 31,2008 at which time inventory levels were reduced to $9.6 million.

 

(4)                                 Cash was used during the year ended October 31,2008 to reduce accounts payable by $3.6 million compared to an increase ofaccounts payable for the year ended October 31, 2007 of $7.7 million.

 

InvestingActivities—During the year ended October 31, 2008, we used $1.4 millionfor investing activities compared to $4.2 million used during the year ended October 31,2007. This difference is due, primarily, to a reduction of capital expendituresafter we began producing ethanol at our plant and the construction had stopped.

 

Financing Activities—Weused $13.5 for financing activities for the year ended October 31, 2008 ascompared to the year ended October 31, 2007 during which we raised $17.4million in cash through financing activities. Contributing to the change werethe following:

 

(1)                                 We repaid $7.0 million on our line ofcredit with AgStar in fiscal year 2008 compared to advances on the line ofcredit of $6.1 million in fiscal year 2007.

 

(2)                                 We received loan proceeds of $4.2million in 2007 from a related party for our purchase of corn inventory andretention of previously purchased corn inventory until our plant was operating.That note was paid in full in fiscal year 2008.

 

(3)                                 We paid down a net of $1.8 million onlong term debt in fiscal year 2008 compared to repayment of $0.3 million infiscal year 2007.

 

(4)                                 We received $7.5 million in proceedsfrom the sale of equity in 2007. There were no such proceeds in fiscal year2008.

 

At October 31, 2008,we had cash balances of approximately $11.4 million. In addition, we hadapproximately $3.8 million of long-term borrowing capacity and $7.1 million ofshort term borrowing capacity, net of outstanding letters of credit.

 

**Off Balance-Sheet Arrangements**

 

We have no offbalance-sheet arrangements.

 

**Credit Arrangements**

 

*Credit Arrangements with AgStar*

 

On September 29,2005, we entered into a credit agreement with AgStar Financial Services, PCA (“AgStar”) establishinga senior credit facility for construction of the plant in the amount of$59,583,000. Simultaneously, we and AgStar entered into a Second Supplementthat provided for a revolving loan in the amount of $2,000,000 to provide forgeneral, corporate and operating expenses. In December 2006, theconstruction loan was amended to increase the amounts available up to$64,583,000. The construction loan converted to a $59,583,000 term note and a$5,000,000 revolving term note in October 2007.   The amount available under the revolvingterm note is reduced each year by $500,000. As of October 31, 2009, the maximum amount of the revolving termnote was $4,000,000.

 

The term note requiredinterest only payments from November 2007 to April 2008 at theone-month LIBOR plus 3.25%, which totaled 3.49%, 5.74% and 9.07% at October 31,2009, 2008 and 2007, respectively. In May 2008, we locked in an interestrate of 3.58% plus 3.00%, which totals 6.58%, on $45,000,000 of the note, forthree years ending April 30, 2011. The remainder of the amountsoutstanding on the term note is subject to the variable rate based on LIBOR. Wewill make equal monthly payments of principal and interest of approximately$640,000 to amortize the note over a period not to exceed ten years, with afinal balloon payment due in October 2012. In addition, we are required tomake additional payments on the term note of excess cash flow, as defined inthe agreement, up to $2,000,000 per year to the lending institution until weneed a specified financial ratio. As part of the debt financing, the premiumabove LIBOR may be reduced based on the ratio of members’ equity to assets.

 

As of October 31,2009, we have used approximately $1.1 million of AgStar’s commitment under therevolving term note.  The term note and revolving term note will mature onOctober 1, 2012.

 

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We also have a line ofcredit with AgStar that is subject to certain borrowing base requirements.  On June 12, 2009, the Company and AgStaragreed upon the terms of the renewal of the Company’s line of credit effective May 29,2009.  Therefore, effective May 29,2009, the Company entered into an Amendment No. 3 to the Fifth Supplement(the “Amendment”) to its master loan agreement, as previously amended andsupplemented, with AgStar.  Among otherthings, the effect of this amendment was to renew the Company’s revolving lineof credit loan at a maximum commitment of $6,750,000 and a maturity date of November 1,2009.  Effective December 8, 2009,the Company and AgStar agreed upon the terms of Amendment No 4 to the FifthSupplement (“Amendment 4”) to its master loan agreement as previously amendedand supplemented.  The effect of thisAmendment 4 was to extend the maturity date of the revolving line of credit to February 1,2010.

 

Amounts available underthe line of credit are reduced by outstanding standby letters of credit.Interest accrues on borrowings at the one month LIBOR plus 3.25%, which totaled3.49%, 5.74% and 9.07% at October 31, 2009, 2008 and 2007, respectively.We must pay a 0.25% commitment fee on the average daily unused portion of theline of credit. At October 31, 2009, 2008 and 2007, outstanding borrowingson the line of credit were $5,000,000, none and $6,974,235, respectively. Wehad an outstanding standby letters of credit of $400,000 at October 31,2008, which expired in November 2008. We had no outstanding standbyletters of credit at October 31, 2009.

 

AgStar has been granted asecurity interest in substantially all of the assets of Heron Lake BioEnergyand its subsidiary, Lakefield Farmers Elevator, LLC. We also assigned to AgStarour interest in our agreements for the sale of ethanol and distillers grains,and for the purchases of coal, corn and electricity, as well as ourdesign-build agreement with Fagen, Inc.  AgStar also received amortgage relating to our real property and that of Lakefield FarmersElevator.  Roland J. (Ron) Fagen personally guarantees our obligationsunder the credit agreement with AgStar, up to a maximum of $3,740,000, througha personal guaranty.  Mr. Fagen did not, and has not, received anyconsideration from us for acting as guarantor.  Fagen, Inc. alsoguaranteed a portion of our indebtedness to AgStar, but this guarantee waseliminated effective October 1, 2007.  The guaranty agreementsspecify certain events of default, including: material breaches ofrepresentations and warranties; failure to perform or comply with any covenantor agreement in the guaranty agreement; or the occurrence of an event ofdefault under the master loan agreement or other loan documents.

 

During the term of theloans, we are subject to certain financial loan covenants consisting of minimumworking capital, minimum debt coverage, and minimum tangible net worth. We areonly allowed to make annual capital expenditures up to $500,000 annuallywithout prior approval. The loan agreements also impose restrictions on ourability to make cash distributions to our members.

 

Upon an occurrence of anevent of default or an event that will lead to our default, AgStar may uponnotice terminate its commitment to loan funds and declare the entire unpaidprincipal balance of the loans, plus accrued interest, immediately due andpayable. An event of default includes, but is not limited to, our failure tomake payments when due, insolvency, any material adverse change in ourfinancial condition or our breach of any of the covenants, representations orwarranties we have given in connection with the transaction.

 

At October 31, 2009as at July 31, 2009, April 30, 2009 and January 31, 2009, theCompany was out of compliance with the minimum working capital requirementprovision of its master loan agreement with AgStar Financial Services, PCA(AgStar). In addition, the Company anticipates that the minimum net worth andfixed charge coverage ratio covenants will not be met through or as of fiscal yearend 2010 unless amended. At January 31, 2009, the Company reclassified thelong-term debt related to this agreement to current liabilities because theCompany was not in compliance with the minimum working capital requirement.That reclassification remains as of October 31, 2009 because of the actualand anticipated covenant default stated above. Additionally, the Companyexpensed the remaining unamortized loan costs totaling approximately $445,000associated with this debt during the quarter ended January 31, 2009.

 

Inconnection with the renewal of the line of credit effective May 29, 2009,AgStar waived the Company’s noncompliance with the working capital covenant ofthe master loan agreement as of and for the periods ending January 31,2009 and April 30, 2009.  AgStaralso waived excess cash flow payment provisions for the year ended October 31,2008 in consideration of an excess cash flow payment by the Company of $94,700on June 12, 2009.  The balance dueof the October 31, 2008 excess cash flow payment in the amount of$1,799,300 is deferred until such time as the Company makes a request to theLender for certain distributions to its members.  On September 9, 2009, AgStar waived theCompany’s noncompliance with the working capital covenant of the master loanagreement for the period ended July 31, 2009. As of October 31, 2009, theunwaived covenant defaults relate to the Company’s default of covenantsrequiring us to maintain at least $5.0 million minimum working capital; atleast $39.5 million of tangible net worth; and a fixed charge ratio of 1.20 to1.00 or greater.

 

IfAgStar exercises its right to accelerate the maturity of the debt outstandingunder the master loan agreement or the line of credit, the Company will nothave adequate available cash to repay the amounts currently outstanding at October 31,2009.  Further, while an event of defaultexists, the Company is not permitted to borrow additional funds under its lineof credit or revolving term note without AgStar’s consent.

 

The Company believes it has sufficient capital resourcesthrough October 31, 2010 based upon its current cash reserves, inventory sales,anticipated revenues and the available borrowing under the master loanagreement, as well as the effect of expense reduction measures, provided thatAgStar extends the maturity date of the revolving line of credit, does notexercise its right to accelerate the maturity of the long term debt, and theCompany is not otherwise required to repay its indebtedness to AgStar under themaster loan agreement on an accelerated basis. The Company’s expense reductionmeasures and cash conservation measures include utilizing and reducing corninventory as well as reducing operating expenses through cost controls.  If the current industry conditions continueand the Company is not able to maintain sufficient funding in the short-term,the Company may be forced to raise additional capital through subordinateddebt, if available, sell additional equity, restructure or significantlycurtail its operations, file for bankruptcy or cease operations.  The financial statements do not include anyadjustments relating to the recoverability and classification of recorded assetamounts or amounts and classification of liabilities that might be necessaryshould the Company be forced to take any such actions*.*

 

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As of October 31,2009, we estimate the fair value of our credit arrangements with AgStar toapproximate $59.8 million, based on contractual terms, which is approximately$229,000 more than its carrying value of $59.5 based on the variable interestrate debt. The fair value of the debt fluctuates to the extent that interestrates are fixed and the current fair value rates are more or less than thefixed rate. While the debt markets have experienced significant volatilityrecently, the fixed rate portion of our long-term debt with AgStar reprices in April 2011and all of the AgStar debt matures in October 2012 and we do not believewe are exposed to any unusual liquidity risks given the long-term nature of ourdebt. The market conditions for credit at the time of maturity of our debt in2012 will determine our ability to refinance our debt and the terms associatedwith refinancing.

 

*Other Credit Arrangements*

 

In addition to ourprimary credit arrangement with AgStar, we have other material creditarrangements and debt obligations.

 

In October 2003, weentered into an industrial water supply development and distribution agreementwith the City of Heron Lake, Jackson County, and Minnesota Soybean Processors.In consideration of this agreement, we and Minnesota Soybean Processors areallocated equally the debt service on $735,000 in water revenue bonds that wereissued by the City to support this project that mature in February 2019.The parties have agreed that prior to the scheduled expiration of theagreement; they will negotiate in good faith to replace the agreement with a furtheragreement regarding the wells and related facilities. In May 2006, weentered into an industrial water supply treatment agreement with the City ofHeron Lake and Jackson County. Under this agreement, we pay monthlyinstallments over 24 months starting January 1, 2007 equal to one years’debt service on approximately $3.6 million in water revenue bonds, which willbe returned to us if any funds remain after final payment in full on the bondsand assuming we comply with all payment obligations under the agreement. As of October 31,2009, there was a total of $3.7 million in outstanding water revenue bonds andwe classify our obligations under these bonds as assessments payable. Theinterest rates on the bonds range from 0.50% to 8.73%.

 

In November 2007, weentered into a shared savings contract with Interstate Power and Light Company(“IPL”), our electrical service provider. Under the agreement, IPL is requiredto pay $1,850,000 to fund project costs for the purchase and installation ofelectrical equipment. In exchange, we are required to share a portion of theenergy savings with IPL that may be derived from the decreased energyconsumption from the new equipment. We are required to pay IPL approximately$30,000 for the first thirteen billing cycles, $140,000 at the end of thethirteenth billing cycle, and thereafter, approximately $30,000 for theremainder of the billing cycles. These amounts represent IPL’s portion of theshared savings. We also granted IPL a security interest in the electricalequipment to be installed on our site. The shared savings contract expires December 31,2012.

 

In connection with theshared savings contract, IPL deposited $1,710,000 of the $1,850,000 in anescrow account on our behalf and we received the remaining $140,000 as cashproceeds. The escrow account expires at the same time as the shared savingscontract or a termination by IPL of the escrow arrangement, at which time anyremaining funds will be distributed to IPL. We earn interest at a rate of 4.2%on the funds escrowed and we pay a rate of interest of 1.5% on the fundsdeposited into escrow. Each month, a distribution from the escrow account ismade to IPL to pay its portion of the shared savings under the shared savingscontract.

 

To fund the purchase ofthe distribution system and substation for the plant, we entered into a loanagreement with Federated Rural Electric Association pursuant to which weborrowed $600,000 by a secured promissory note.  Under the note we are required to make monthlypayments to Federated Rural Electric Association of $6,250 consisting ofprincipal and an annual fee of 1% beginning on October 10, 2009. Inexchange for this loan, Federated Rural Electric Association was granted asecurity interest in the distribution system and substation for the plant.  The balance of this loan at October 31,2009 was $593,750.

 

**ITEM 7A.****             ****QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

We are a smallerreporting company, as defined by Rule 12b-2 of the Exchange Act, andtherefore are not required to provide the information under this Item.

 

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**ITEM 8.********FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

 

The following financialstatements are included in this Annual Report on Form 10-K beginning atthe “F” page noted:

 
| ** **                                                                                                                  | ** ** | **Page Reference** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|
| Management’s Report on Internal Control Over Fianancial  Reporting                                                     |       | F-1                     |
|                                                                                                                        |       |                    |
| Report of Independent Registered Public Accounting Firm                                                                     |       | F-2                     |
|                                                                                                                        |       |                    |
| Consolidated Balance Sheets as of October 31, 2009  and 2008                                                           |       | F-3                     |
|                                                                                                                        |       |                    |
| Consolidated Statements of Operations for the fiscal  years ended October 31, 2009, 2008 and 2007                      |       | F-5                     |
|                                                                                                                        |       |                    |
| Consolidated Statements of Changes in Members’ Equity  for the fiscal years ended October 31, 2009, 2008 and 2007 |       | F-6                     |
|                                                                                                                        |       |                    |
| Consolidated  Statements of Cash Flows for the fiscal years ended October 31, 2009,  2008 and 2007                     |       | F-7                     |
|                                                                                                                        |       |                    |
| Notes to Consolidated Financial Statements                                                                                  |       | F-9                     |

 

**ITEM 9.****                      ****CHANGES IN ANDDISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None.

 

**ITEM 9A.T.****             ****CONTROLS AND PROCEDURES**

 

**Evaluation of Disclosure Controls andProcedures**

 

We maintain a system of “disclosurecontrols and procedures,” as defined by Rules 13a-15(e) and 15d-15(e) ofthe Securities Exchange Act of 1934, as amended.

 

Our Chief ExecutiveOfficer, Robert J. Ferguson, and Interim Chief FinancialOfficer, Brett L. Frevert, have evaluated our disclosurecontrols and procedures as of the end of the period covered by this report.Based upon their review, they have concluded that these controls and proceduresare effective.

 

**Changes in Internal Controls overFinancial Reporting**

 

Inconnection with the audit of our financial statements for our fiscal year endedOctober 31, 2008, we identified material weaknesses in our internal controlover financial reporting relating to lack of segregation of duties, period-endclosing procedures, and inadequate number of accounting department personnel.No material weaknesses will be considered remediated until the remedialprocedures have operated for an appropriate period, have been tested andmanagement has concluded that they are operating effectively. During fiscalyear 2009, we completed a plan to address these material weaknesses including:

 

·      Implementingpolicies with regards to the segregation of duties specifically as they relateto cash transactions;

 

·      Improvingperiod-end closing procedures that resulted in a more timely close; and

 

·      Improvingthe review process to evaluate the accuracy of the financial statements andsupplemental reports.

 

Asa small business, the Company does not have the resources to fund sufficientstaff to ensure a complete segregation of responsibilities within theaccounting function. However, Company management reviews financial statementsand bank reconciliations on a monthly basis, along with the adoption of amonthly financial closing process. These actions, in addition to theimprovements identified above, will minimize any risk of a potential materialmisstatement occurring.

 

There have been nochanges in internal control over financial reporting other than thoseidentified above that occurred during the fourth fiscal quarter that havematerially affected, or are reasonably likely to materially affect, our internalcontrol over financial reporting.

 

The Company’s internalcontrol report is included in this Annual Report on Form 10-K under Item8, “Financial Statements and Supplementary Data” under the caption “Management’sReport on Internal Control Over Financial Reporting.”

 

**ITEM 9B.****             ****OTHER INFORMATION**

 

Effective December 8,2009, HLBE and AgStar agreed upon the terms of Amendment No. 4 to theFifth Supplement to its master loan agreement as previously amended andsupplemented.  The effect of thisAmendment No. 4 was to extend the maturity date of the revolving line ofcredit to February 1, 2010.  Theline of credit has a maximum commitment of $6,750,000.  A copy of the Amendment No. 4 isattached to this Form 10-K as Exhibit 10.32.

 

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**PART III**

 

**ITEM 10.****             ****DIRECTORS, EXECUTIVE OFFICERS ANDCORPORATE GOVERNANCE**

 

Theinformation required by this item is incorporated herein by reference to thefollowing sections of the Company’s Proxy Statement for its 2010 Annual Meetingof Shareholders, which will be filed with the Securities and ExchangeCommission pursuant to Regulation 14A within 120 days after the closeof the fiscal year for which this report is filed (the “Proxy Statement”):

 

·                              Ownership of Units by Principal Holders andManagement;

 

·                              Proposal 1: Election of Governors;

 

·                              Corporate Governance;

 

·                              Executive Officers and Executive Compensation;

 

·                              Certain Relationships and Related Person Transactions;

 

·                              Section 16(a) Beneficial Ownership ReportingCompliance; and

 

·                              Code of Ethics.

 

**ITEM 11.               EXECUTIVE COMPENSATION**

 

Theinformation required by this item is incorporated herein by reference to thesections of the Company’s Proxy Statement entitled “Executive Officers andExecutive Compensation” and “Governor Compensation.”

 

**ITEM 12.               SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS**

 

Theinformation required by this item is incorporated herein by reference to thesection of the Company’s Proxy Statement entitled “Ownership of Units byPrincipal Holders and Management,” and is incorporated herein by reference to Part II,Item 5 entitled “Market for Registrant’s Common Equity, Related StockholderMatters and Issuer Purchases of Equity Securities” of this Annual Report on Form 10-K.

 

**ITEM 13.               CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS AND DIRECTOR INDEPENDENCE**

 

Theinformation required by this item is incorporated by reference to the sectionsof the Company’s Proxy Statement entitled “Certain Relationships and RelatedPerson Transactions” and “Corporate Governance.”

 

**ITEM 14.               PRINCIPAL ACCOUNTANT FEES ANDSERVICES**

 

Theinformation required by this item is incorporated herein by reference to thesection of the Company’s Proxy Statement entitled “Relationship withIndependent Accountants.”

 

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** **

**PART IV**

 

**ITEM 15.****              ****EXHIBITS AND FINANCIALSTATEMENTS SCHEDULES**

 

(a)              Financial Statements

 
| ** **                                                                                                                  | ** ** | **Page Reference** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|
|                                                                                                                        |       |                    |
| Audited Financial Statements                                                                                                |       |                    |
|                                                                                                                        |       |                    |
| Management’s Report on Internal Control Over Fianancial  Reporting                                                     |       | F-1                     |
|                                                                                                                        |       |                    |
| Report of Independent Registered Public Accounting  Firm                                                                    |       | F-2                     |
|                                                                                                                        |       |                    |
| Consolidated Balance Sheets as of October 31,  2009 and 2008                                                           |       | F-3                     |
|                                                                                                                        |       |                    |
| Consolidated Statements of Operations for the fiscal  years ended October 31, 2009, 2008 and 2007                      |       | F-5                     |
|                                                                                                                        |       |                    |
| Consolidated Statements of Changes in Members’ Equity  for the fiscal years ended October 31, 2009, 2008 and 2007 |       | F-6                     |
|                                                                                                                        |       |                    |
| Consolidated Statements of Cash Flows for the fiscal  years ended October 31, 2009, 2008 and 2007                      |       | F-7                     |
|                                                                                                                        |       |                    |
| Notes to Consolidated Financial Statements                                                                                  |       | F-9                     |

 

(b)             Exhibits

 

See “Exhibit Index” on the page followingthe Signature Page.

 

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**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
| Dated:  January 29, 2010 |                                        |
|-----------------------------------------|---------------------------------------------|
|                                    |                                        |
|                                    | **HERON LAKE BIOENERGY, LLC**               |
|                                    |                                        |
|                                    |                                        |
|                                    | By:                                         | /s/ Robert J. Ferguson |
|                                    | Robert J. Ferguson, Chief Executive Officer |
|                                    | (principal executive officer)               |

 

Each person whosesignature appears below hereby constitutes and appoints Robert J.Ferguson  and Brett L. Frevert, and each of them, as his true and lawfulattorney-in-fact and agent, with full power of substitution, to sign on hisbehalf, individually and in each capacity stated below, all amendments to this Form 10-Kand to file the same, with all exhibits thereto and any other documents inconnection therewith, with the Securities and Exchange Commission, grantingunto said attorneys-in-fact and agents full power and authority to do andperform each and every act and thing requisite and necessary to be done in andabout the premises, as fully and to all intents and purposes as each might orcould do in person, hereby ratifying and confirming each act that saidattorneys-in-fact and agents may lawfully do or cause to be done by virtuethereof.

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below on behalf of the registrant by the following persons in thecapacities indicated on January29, 2010.

 
| /s/ Robert J. Ferguson  |   | Chief Executive Officer and President      |
|-------------------------|--------|--------------------------------------------|
| Robert J. Ferguson      |   | (principal executive officer), Governor    |
|                    |   |                                       |
| /s/ Brett L. Frevert    |   | Interim Chief Financial Officer (principal |
| Brett L. Frevert        |   | financial and accounting officer)          |
|                    |   |                                       |
| /s/ Doug Schmitz        |   | Governor                                   |
| Doug Schmitz            |   |                                       |
|                    |   |                                       |
| /s/ Michael S. Kunerth  |   | Governor                                   |
| Michael S. Kunerth      |   |                                       |
|                    |   |                                       |
| /s/ David J. Woestehoff |   | Governor                                   |
| David J. Woestehoff     |   |                                       |
|                    |   |                                       |
| /s/ David J. Bach       |   | Governor                                   |
| David J. Bach           |   |                                       |
|                    |   |                                       |
| /s/ Timothy O. Helgemoe |   | Governor                                   |
| Timothy O. Helgemoe     |   |                                       |
|                    |   |                                       |
| /s/ Milton J. McKeown   |   | Governor                                   |
| Milton J. McKeown       |   |                                       |
|                    |   |                                       |
| /s/ David M. Reinhart   |   | Governor                                   |
| David M. Reinhart       |   |                                       |
|                    |   |                                       |
| /s/ Chad Core           |   | Governor                                   |
| Chad Core               |   |                                       |
|                    |   |                                       |
| /s/ Robert J. Wolf      |   | Governor                                   |
| Robert J. Wolf          |   |                                       |

 

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**Management’s Report on InternalControl over Financial Reporting**

 

The Board of Directorsand Members of Heron Lake BioEnergy, LLC:

 

Management is responsiblefor establishing and maintaining adequate internal control over financialreporting as defined in Rules 13a15-(f) and 15d-15(f) under the SecuritiesExchange Act of 1934. The Company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. Acompany’s internal control over financial reporting includes those policies andprocedures that:

 

(i) pertainto the maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the Company;

 

(ii) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the Company arebeing made only in accordance with authorizations of management and directorsof the Company; and

 

(iii) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use or disposition of the Company’s assets that could have amaterial effect on the financial statements.

 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

 

Under the supervision ofour Chief Executive Officer and our Interim Chief Financial Officer, weconducted an evaluation of the effectiveness of our internal control overfinancial reporting based on the framework in *InternalControl— Integrated Framework*issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO).

 

A material weakness(within the meaning of PCAOB Auditing Standard No. 2) is a controldeficiency, or a combination of control deficiencies, that results in more thana remote likelihood that a material misstatement of the annual or interimfinancial statements will not be prevented or detected.

 

In conducting theaforementioned evaluation, management concluded that the Company’s internalcontrol over financial reporting was effective as of October 31, 2009.

 

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REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

Board of Governors

Heron Lake BioEnergy, LLC and Subsidiary

Heron Lake, Minnesota

 

We have audited the accompanying consolidated balancesheets of Heron Lake BioEnergy, LLC and Subsidiary as of October 31, 2009and 2008, and the related consolidated statements of operations, changes inmembers’ equity, and cash flows for each of the fiscal years in the three-yearperiod ended October 31, 2009.  Heron Lake BioEnergy, LLC andSubsidiary’s management is responsible for these financial statements. Ourresponsibility is to express an opinion on these financial statements based onour audits.

 

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. The company is not required to have, nor were we engaged toperform, an audit of its internal control over financial reporting. Our auditincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of thecompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Heron Lake BioEnergy, LLC and Subsidiary as of October 31,2009 and 2008, and the results of its operations and its cash flows for each ofthe fiscal years in the three-year period ended October 31, 2009 inconformity with accounting principles generally accepted in the United Statesof America.

 

The accompanying financial statements have beenprepared assuming that the Company will continue as a going concern.  As discussed in Note 2 to the financialstatements, the Company has incurred a loss of approximately $11.3 million forthe fiscal year ending October 31, 2009. The Company was also out of compliance of its master loan agreement andreclassified the long term debt related to this agreement to currentliabilities.  If the right to acceleratethe maturity of the debt outstanding under the master loan agreement or theline of credit were to be exercised, the Company will not have adequateavailable cash to repay the amounts currently outstanding.  These conditions raise substantial doubtabout the Company’s ability to continue as a going concern.  Management’s plans regarding those mattersalso are described in Note 2.  Thefinancial statements do not include any adjustments that might result from theoutcome of this uncertainty.

 

 
|   | /s/ Boulay, Heutmaker, Zibell & Co.  P.L.L.P. |
|--------|--------------------------------------------------------|
|   |                                                   |
|   | Certified Public Accountants                           |

 

Minneapolis, Minnesota

January 29, 2010

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

ConsolidatedBalance Sheets

 
| ** **                       | ** ** | **October 31, 2009** | ** **  | **October 31, 2008** | ** ** |
|----------------------------------|------------|--------------------------------|-------------|--------------------------------|------------|
|                             |       |                           |        |                           |       |
| **ASSETS**                       |       |                           |        |                           |       |
| **Current  Assets**              |       |                           |        |                           |       |
| Cash and equivalents             |       | $                              | 3,184,074   |                           | $          | 11,355,075 |   |
| Restricted cash                  |       | 340,644                        |        | 1,499,472                      |       |
| Accounts receivable              |       | 4,439,701                      |        | 3,368,076                      |       |
| Inventory                        |       | 4,752,117                      |        | 9,633,749                      |       |
| Derivative instruments           |       | —                         |        | 750,172                        |       |
| Prepaid expenses                 |       | 210,136                        |        | 616,641                        |       |
| Total current assets             |       | 12,926,672                     |        | 27,223,185                     |       |
|                             |       |                           |        |                           |       |
| **Property  and Equipment**      |       |                           |        |                           |       |
| Land and improvements            |       | 12,574,760                     |        | 12,552,721                     |       |
| Plant buildings and  equipment   |       | 97,332,591                     |        | 97,159,759                     |       |
| Vehicles and other  equipment    |       | 604,783                        |        | 597,921                        |       |
| Office buildings and  equipment  |       | 618,437                        |        | 597,508                        |       |
|                             |       | 111,130,571                    |        | 110,907,909                    |       |
| Accumulated  depreciation        |       | (12,569,966                    | )           | (7,025,870                     | )          |
|                             |       | 98,560,605                     |        | 103,882,039                    |       |
|                             |       |                           |        |                           |       |
| **Other  Assets**                |       |                           |        |                           |       |
| Deferred loan costs,  net        |       | —                         |        | 467,128                        |       |
| Restricted cash                  |       | 718,790                        |        | 995,804                        |       |
| Other intangibles                |       | 488,010                        |        | 464,304                        |       |
| Debt service deposits  and other |       | 395,200                        |        | 368,350                        |       |
| Total other assets               |       | 1,602,000                      |        | 2,295,586                      |       |
|                             |       |                           |        |                           |       |
| **Total  Assets**                |       | $                              | 113,089,277 |                           | $          | 133,400,810 |   |

 

Notes to ConsolidatedFinancial Statements are an integral part of this Statement.

 

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**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

ConsolidatedBalance Sheets

 
| ** **                                                            | ** ** | **October 31, 2009** | ** **  | **October 31, 2008** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------|-------------|--------------------------------|------------|
|                                                                  |       |                           |        |                           |       |
| **LIABILITIES  AND MEMBERS’ EQUITY**                             |       |                           |        |                           |       |
| **Current  Liabilities**                                              |       |                           |        |                           |       |
| Line of credit                                                        |       | $                              | 5,000,000   |                           | $          | — |   |
| Current maturities of  long-term debt                                 |       | 55,224,183                     |        | 5,649,354                      |       |
| Accounts payable:                                                     |       |                           |        |                           |       |
| Trade accounts payable                                                |       | 2,466,040                      |        | 5,635,204                      |       |
| Trade accounts payable  - related party                               |       | 714,115                        |        | 792,450                        |       |
| Construction payable -  related party                                 |       | 3,839,413                      |        | 3,839,413                      |       |
| Accrued expenses                                                      |       | 566,481                        |        | 512,709                        |       |
| Lower of cost or market  adjustment                                   |       | 1,249,495                      |        | 7,122,966                      |       |
| Total current  liabilities                                            |       | 69,059,727                     |        | 23,552,096                     |       |
|                                                                  |       |                           |        |                           |       |
| **Long-Term  Debt,** net of  current maturities                       |       | 4,775,804                      |        | 59,265,534                     |       |
|                                                                  |       |                           |        |                           |       |
| **Commitments  and Contingencies**                                    |       |                           |        |                           |       |
|                                                                  |       |                           |        |                           |       |
| **Members’  Equity,**  27,104,625 Class A units outstanding |       | 39,253,746                     |        | 50,583,180                     |       |
|                                                                  |       |                           |        |                           |       |
| **Total  Liabilities and Members’ Equity**                       |       | $                              | 113,089,277 |                           | $          | 133,400,810 |   |

 

Notes to ConsolidatedFinancial Statements are an integral part of this Statement.

 

F-4

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Table of Contents

 

**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

ConsolidatedStatements of Operations

 
| ** **                                                  | ** ** | **Year Ended**            | ** **  | **Year Ended**            | ** ** | **Year Ended**            | ** ** |
|-------------------------------------------------------------|------------|--------------------------------|-------------|--------------------------------|------------|--------------------------------|------------|
| ** **                                                  | ** ** | **October 31, 2009** | ** **  | **October 31, 2008** | ** ** | **October 31, 2007** | ** ** |
|                                                        |       |                           |        |                           |       |                           |       |
| **Revenues**                                                |       | $                              | 88,304,596  |                           | $          | 131,070,642                    |       | $ | 23,560,498 |   |
|                                                        |       |                           |        |                           |       |                           |       |
| **Cost  of Goods Sold**                                     |       |                           |        |                           |       |                           |       |
| Cost of goods sold                                          |       | 85,448,407                     |        | 105,660,541                    |       | 24,313,695                     |       |
| Lower of cost or market  adjustment                         |       | 5,408,840                      |        | 8,751,000                      |       | —                         |       |
| **Total  Cost of Goods Sold**                               |       | 90,857,247                     |        | 114,411,541                    |       | 24,313,695                     |       |
|                                                        |       |                           |        |                           |       |                           |       |
| **Gross  Profit (Loss)**                                    |       | (2,552,651                     | )           | 16,659,101                     |       | (753,197                       | )          |
|                                                        |       |                           |        |                           |       |                           |       |
| **Operating  Expenses**                                     |       | 4,515,476                      |        | 3,351,252                      |       | 3,527,199                      |       |
|                                                        |       |                           |        |                           |       |                           |       |
| **Operating  Income (Loss)**                                |       | (7,068,127                     | )           | 13,307,849                     |       | (4,280,396                     | )          |
|                                                        |       |                           |        |                           |       |                           |       |
| **Other  Income (Expense)**                                 |       |                           |        |                           |       |                           |       |
| Interest income                                             |       | 78,320                         |        | 84,078                         |       | 9,166                          |       |
| Interest expense                                            |       | (4,014,448                     | )           | (4,807,965                     | )          | (1,181,442                     | )          |
| Write off of loan costs                                     |       | (444,985                       | )           | —                         |       | —                         |       |
| Other income                                                |       | 119,806                        |        | 34,077                         |       | 4,386                          |       |
| **Total  other expense**                                    |       | (4,261,307                     | )           | (4,689,810                     | )          | (1,167,890                     | )          |
|                                                        |       |                           |        |                           |       |                           |       |
| **Net  Income (Loss)**                                      |       | $                              | (11,329,434 | )                              | $          | 8,618,039                      |       | $ | (5,448,286 | ) |
|                                                        |       |                           |        |                           |       |                           |       |
| **Weighted  Average Units Outstanding - Basic and Diluted** |       | 27,104,625                     |        | 27,104,625                     |       | 26,361,406                     |       |
|                                                        |       |                           |        |                           |       |                           |       |
| **Net  Income (Loss) Per Unit - Basic and Diluted**         |       | $                              | (0.42       | )                              | $          | 0.32                           |       | $ | (0.21 | ) |

 

Notes to ConsolidatedFinancial Statements are an integral part of this Statement.

 

F-5

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Table of Contents

 

**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

ConsolidatedStatements of Changes in Members’ Equity

 
| **Balance  - October 31, 2006**                                                                          |       | 39,733,427  |       |
|---------------------------------------------------------------------------------------------------------------|------------|-------------|------------|
|                                                                                                          |       |        |       |
| Capital Contribution -  3,750,000 Class A units, $2.00 per unit, December 2006                      |       | 7,500,000   |       |
|                                                                                                          |       |        |       |
| Capital Contribution -  exercise of warrants for 225,000 Class A units, $.80 per unit,  August 2007 |       | 180,000     |       |
|                                                                                                          |       |        |       |
| Net loss for the year  ended October 31, 2007                                                            |       | (5,448,286  | )          |
|                                                                                                          |       |        |       |
| **Balance  - October 31, 2007**                                                                          |       | 41,965,141  |       |
|                                                                                                          |       |        |       |
| Net income for the year  ended October 31, 2008                                                          |       | 8,618,039   |       |
| ** **                                                                                                    | ** ** | ** **  | ** ** |
| **Balance  - October 31, 2008**                                                                          |       | 50,583,180  | ** ** |
| ** **                                                                                                    | ** ** | ** **  | ** ** |
| Net loss for the year  ended October 31, 2009                                                            |       | (11,329,434 | )          |
|                                                                                                          |       |        |       |
| **Balance  - October 31, 2009**                                                                          |       | $           | 39,253,746 |   |
|                                                                                                               |            |             |            |  |

 

Notes to ConsolidatedFinancial Statements are an integral part of this Statement.

 

F-6

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Table of Contents

 

 **HERON LAKE BIOENERGY, LLC AND SUBSIDIARY**

 

ConsolidatedStatements of Cash Flows

 
| ** **                                                                                           | ** ** | **Year**                       | ** **  | **Year**                       | ** ** | **Year**                       | ** ** |
|------------------------------------------------------------------------------------------------------|------------|--------------------------------|-------------|--------------------------------|------------|--------------------------------|------------|
| ** **                                                                                           | ** ** | **Ended**                      | ** **  | **Ended**                      | ** ** | **Ended**                      | ** ** |
| ** **                                                                                           | ** ** | **October 31, 2009** | ** **  | **October 31, 2008** | ** ** | **October 31, 2007** | ** ** |
|                                                                                                 |       |                           |        |                           |       |                           |       |
| **Cash  Flow From Operating Activities**                                                             |       |                           |        |                           |       |                           |       |
| Net income (loss)                                                                                    |       | $                              | (11,329,434 | )                              | $          | 8,618,039                      |       | $ | (5,448,286 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                           |        |                           |       |                           |       |
| Depreciation and  amortization                                                                       |       | 5,645,311                      |        | 5,688,300                      |       | 1,269,117                      |       |
| Amortization of loan  costs included with interest expense                                           |       | 22,143                         |        | —                         |       | —                         |       |
| Write off of loan costs                                                                              |       | 444,985                        |        | —                         |       | —                         |       |
| Lower of cost or market  adjustment                                                                  |       | 5,408,840                      |        | 8,751,000                      |       | —                         |       |
| Unrealized (gains)  losses on derivative instruments                                                 |       | —                         |        | (678,713                       | )          | 150,088                        |       |
| (Gain)/loss on disposal  of assets                                                                   |       | (38,301                        | )           | 3,317                          |       | (4,396                         | )          |
| Change in operating assets  and liabilities:                                                         |       |                           |        |                           |       |                           |       |
| Restricted cash                                                                                      |       | 1,021,767                      |        | (803,383                       | )          | 291,500                        |       |
| Accounts receivable                                                                                  |       | (1,071,625                     | )           | (1,413,950                     | )          | (1,550,443                     | )          |
| Inventory                                                                                            |       | 4,529,174                      |        | 7,729,607                      |       | (14,861,633                    | )          |
| Derivative instruments                                                                               |       | 750,172                        |        | (257,695                       | )          | (879,384                       | )          |
| Prepaid expenses                                                                                     |       | 406,505                        |        | (491,783                       | )          | (51,784                        | )          |
| Accounts payable                                                                                     |       | (3,247,499                     | )           | (3,611,106                     | )          | 7,718,778                      |       |
| Accrued expenses                                                                                     |       | 53,771                         |        | (341,041                       | )          | 645,577                        |       |
| Accrued lower of cost  or market adjustments                                                         |       | (10,929,853                    | )           | —                         |       | —                         |       |
| Net cash provided by  (used in) operating activities                                                 |       | (8,334,044                     | )           | 23,192,592                     |       | (12,720,866                    | )          |
|                                                                                                 |       |                           |        |                           |       |                           |       |
| **Cash  Flows from Investing Activities**                                                            |       |                           |        |                           |       |                           |       |
| Proceeds from sale of assets                                                                         |       | 177,516                        |        | 224,498                        |       | 29,421                         |       |
| Capital expenditures                                                                                 |       | (349,521                       | )           | (1,186,148                     | )          | (4,204,339                     | )          |
| Payment for other  intangibles                                                                       |       | (59,835                        | )           | (474,183                       | )          | —                         |       |
| Net cash used in  investing activities                                                               |       | (231,840                       | )           | (1,435,833                     | )          | (4,174,918                     | )          |
|                                                                                                 |       |                           |        |                           |       |                           |       |
| **Cash  Flows from Financing Activities**                                                            |       |                           |        |                           |       |                           |       |
| Checks written in  excess of bank balance                                                            |       | —                         |        | (514,633                       | )          | (8,972                         | )          |
| Proceeds from (payments  on) line of credit, net                                                     |       | 5,000,000                      |        | (6,974,235                     | )          | 6,126,175                      |       |
| Proceeds from (payments  on) note payable - related party                                            |       | —                         |        | (4,202,930                     | )          | 4,202,930                      |       |
| Proceeds from long-term  debt                                                                        |       | —                         |        | 3,289,177                      |       | —                         |       |
| Payments on long-term  debt                                                                          |       | (4,992,343                     | )           | (5,113,249                     | )          | (307,168                       | )          |
| Payments for loan costs                                                                              |       | —                         |        | —                         |       | (179,166                       | )          |
| Debt service deposits                                                                                |       | (26,850                        | )           | (215,600                       | )          | (151,750                       | )          |
| Release of restricted  cash                                                                          |       | 414,076                        |        | 239,457                        |       | —                         |       |
| Member contributions                                                                                 |       | —                         |        | —                         |       | 7,500,000                      |       |
| Member contributions  related to warrants exercised                                                  |       | —                         |        | —                         |       | 180,000                        |       |
| Net cash provided by  (used in) financing activities                                                 |       | 394,883                        |        | (13,492,013                    | )          | 17,362,049                     |       |
|                                                                                                 |       |                           |        |                           |       |                           |       |
| **Net  Increase (Decrease) in cash and equivalents**                                                 |       | (8,171,001                     | )           | 8,264,746                      |       | 466,265                        |       |
|                                                                                                 |       |                           |        |                           |       |                           |       |
| **Cash  and Equivalents - Beginning of period**                                                      |       | 11,355,075                     |        | 3,090,329                      |       | 2,624,064                      |       |
|                                                                                                 |       |                           |        |                           |       |                           |       |
| **Cash  and Equivalents - End of period**                                                            |       | $                              | 3,184,074   |                           | $          | 11,355,075                     |       | $ | 3,090,329 |   |

 

Notes to ConsolidatedFinancial Statements are an integral part of this Statement.

 

F-7

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Table of Contents

 

**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Consolidated Statementsof Cash Flows

 
| ** **                                            | ** ** | **Year**                       | ** ** | **Year**                       | ** ** | **Year**                       | ** ** |
|-------------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                                            | ** ** | **Ended**                      | ** ** | **Ended**                      | ** ** | **Ended**                      | ** ** |
| ** **                                            | ** ** | **October 31, 2009** | ** ** | **October 31, 2008** | ** ** | **October 31, 2007** | ** ** |
|                                                  |       |                           |       |                           |       |                           |       |
| **Supplemental  Disclosure of Cash Flow Information** |       |                           |       |                           |       |                           |       |
| Interest expense paid                                 |       | $                              | 4,040,240  |                           | $          | 5,100,895                      |       | $ | 589,118 |   |
| Interest capitalized  paid                            |       | —                         |       | —                         |       | 2,802,010                      |       |
| Total interest paid                                   |       | $                              | 4,040,240  |                           | $          | 5,100,895                      |       | $ | 3,391,128 |   |
|                                                  |       |                           |       |                           |       |                           |       |
| **Supplemental  Disclosure of Non-Cash Activities**   |       |                           |       |                           |       |                           |       |
| Restricted cash from  long-term debt proceeds         |       | $                              | —     |                           | $          | 1,710,000                      |       | $ | — |   |
| Property and equipment  in construction payables      |       | $                              | —     |                           | $          | 3,839,413                      |       | $ | 4,188,455 |   |
| Property and equipment  financed by long-term debt    |       | $                              | —     |                           | $          | —                         |       | $ | 40,245,680 |   |
| Assessment payable  related to property and equipment |       | $                              | —     |                           | $          | —                         |       | $ | 867,500 |   |
| Loan costs capitalized  with property and equipment   |       | $                              | —     |                           | $          | —                         |       | $ | 99,387 |   |
| Construction payables  refinanced with long-term debt |       | $                              | —     |                           | $          | —                         |       | $ | 14,882,948 |   |

 

Notes to ConsolidatedFinancial Statements are an integral part of this Statement.

 

F-8

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Table of Contents

 

**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes toConsolidated Financial Statements

 

October 31, 2009 and2008

 

**1. SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES**

 

*Nature of Business*

 

The Company owns and operates a 50 million gallonethanol plant near Heron Lake, Minnesota with ethanol distribution to upperMidwest states.  In addition, the Company produces and sells distillersgrains with solubles as co-products of ethanol production.  The Companywas formed on April 12, 2001 to have an indefinite life.  The Companybegan its ethanol plant operations in September 2007.  Prior to September 2007,the Company was in the development stage.

 

*Principles of Consolidation*

 

The financial statements include the accounts of HeronLake BioEnergy, LLC and its wholly owned subsidiary, Lakefield FarmersElevator, LLC, collectively, the “Company.”  All significant intercompanybalances and transactions are eliminated in consolidation.

 

*Fiscal Reporting Period*

 

The Company’s fiscal year end for reporting financialoperations is October 31.

 

*Accounting Estimates*

 

Management uses estimates and assumptions in preparingthese financial statements in accordance with generally accepted accounting principles. Those estimates and assumptions affect the reported amounts of assets andliabilities, the disclosure of contingent assets and liabilities, and thereported revenues and expenses.   The Company uses estimates andassumptions in accounting for significant matters including, among others, thecarrying value and useful lives of property and equipment, analysis ofimpairment on long-lived assets, and valuation of forward purchase contractcommitments and inventory.  The Company periodically reviews estimates andassumptions, and the effects of revisions are reflected in the period in whichthe revision is made. Actual results could differ from those estimates.

 

*Revenue Recognition*

 

Revenue from sales is recorded when title transfers to the customer, collectionof the relevant receivable is probable, persuasive evidence of an arrangementexists, and the sales price is fixed and determinable.    Thetitle transfers when the product is loaded into the railcar or truck, thecustomer takes ownership and assumes risk of loss.

 

F-9

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Table of Contents

 

**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to ConsolidatedFinancial Statements

 

October 31, 2009 and2008

 

*Cash and Equivalents*

 

The Company considers all highly liquid debtinstruments purchased with a maturity of three months or less to be cash andequivalents.

 

The Company maintains its accounts at five financialinstitutions.  At times throughout the year, the Company’s cash balancesmay exceed amounts insured by the Federal Deposit Insurance Corporation and theSecurities Investor Protection Corporation.  The Company does not believeit is exposed to any significant credit risk on cash and equivalents.

 

*Restricted Cash*

 

The Company is periodically required to maintain cashbalances at its broker related to derivative instrument positions.  Inaddition, at October 31, 2009 the Company maintained restricted cash ofapproximately $341,000 related to a loan agreement as described in Note 10.

 

*Accounts Receivable*

 

Credit terms are extended to customers in the normalcourse of business.   The Company performs ongoing credit evaluationsof its customers’ financial condition and, generally, requires no collateral.

 

Accounts receivable are recorded at estimated netrealizable value.   Accounts are considered past due if payment isnot made on a timely basis in accordance with the Company’s credit terms. Accounts considered uncollectible are written off.  The Company’s estimateof the allowance for doubtful accounts is based on historical experience, itsevaluation of the current status of receivables, and unusual circumstances, ifany.  At October 31, 2009 and 2008, the Company was of the belief thatsuch accounts would be collectable and thus an allowance was not considerednecessary.

 

*Inventory*

 

Inventory consists of raw materials, work in process,finished goods, supplies, and other grain inventory. Corn is the primary rawmaterial and, along with other raw materials and supplies, is stated at thelower of cost or market on a first-in, first-out (FIFO) basis.  Work inprocess and finished goods, which consists of ethanol and distillers grainsproduced, is stated at the lower of average cost or market.  Other graininventory, which consists of agricultural commodities, is valued at marketvalue (net realizable value).  Other grain inventory is readilyconvertible to cash because of its commodity characteristics, widely availablemarkets and international pricing mechanisms.  Other grain inventory isalso freely traded, has quoted market prices, may be sold without significantfurther processing, and has predictable and insignificant disposal costs. Merchandise inventory is valued at lower of cost or market on a first-in,first-out (FIFO) basis.

 

Costs of sales also include expenses directlyattributable to the repair and maintenance of the plant.  During thefiscal year ended October 31, 2009, we incurred costs of approximately$300,000 as part of a five day planned annual shutdown and maintenanceprocedure.  Upon shutdown, portions of the refractory section of theboiler collapsed.  While there were no injuries sustained, significantadditional time and costs were incurred to secure the refractory, ensure thesafety of the workers completing repairs and to complete the repairs. This added eleven days to the shutdown for a total of sixteen days shutdownduring May.  Costs associated with the unusual repairs were approximately$700,000 and are included in operating expenses

 

F-10

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Table of Contents

 

**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to ConsolidatedFinancial Statements

 

October 31, 2009 and2008

 

*Derivative Instruments*

 

Fromtime to time, the Company enters into derivative transactions to protect grossmargins from potentially adverse effects of market and price volatility infuture periods.  In order to reduce the risks caused by marketfluctuations, the Company hedges a portion of its anticipated corn and naturalgas purchases, and ethanol sales by entering into options and futurescontracts.  These contracts are used with the intention to fix thepurchase price of anticipated requirements for corn and natural gas in theCompany’s ethanol production activities and the related sales price of ethanolproduced.  The fair value of these contracts is based on quoted prices inactive exchange-traded or over-the-counter market conditions.

 

TheCompany generally does not designate these derivative instruments as hedges foraccounting purposes and derivative positions are recorded on the balance sheetat their fair market value, with changes in fair value caused from marking theseinstruments to market, recognized in current period earnings or losses on amonthly basis.  While the Company does not designate the derivativeinstruments that it enters into as hedging instruments because of theadministrative costs associated with the related accounting, the Companybelieves that the derivative instruments represent an economic hedge.

 

Inorder for a derivative to qualify as a hedge, specific criteria must be met andappropriate documentation maintained.  If the derivative does qualify as ahedge, depending on the nature of the hedge, changes in the fair value of thederivative will be either offset against the change in fair value of the hedgedassets, liabilities, or firm commitments through earnings or recognized inother comprehensive income until the hedged item is recognized inearnings.  Gains and losses from derivatives that do not qualify ashedges, or are undesignated, must be recognized immediately in earnings.

 

TheCompany evaluates its contracts to determine whether the contracts arederivatives.  Certain contracts that literally meet the definition of aderivative may be exempted as “normal purchases or normal sales.”  Normalpurchases and normal sales are contracts that provide for the purchase or saleof something other than a financial instrument or derivative instrument thatwill be delivered in quantities expected to be used or sold over a reasonableperiod in the normal course of business.  Certain corn, ethanol anddistillers grains contracts that meet the requirement of normal purchases orsales are documented as normal and exempted from the accounting and reportingrequirements, and therefore, are not marked to market in our financialstatements.

 

*Other Intangibles*

 

Other intangibles are stated at cost and include roadimprovements located near the plant in which the Company has a beneficialinterest in but does not own the road.  The Company amortizes  the assets over the economic useful life of15 years.

 

*Property and Equipment*

 

Property and equipment are recorded at cost. Depreciation is provided over an estimated useful life by use of thestraight-line deprecation method.  Maintenance and repairs are expensed asincurred; major improvements and betterments are capitalized. Construction in progress is comprised of costs related to the construction ofthe ethanol plant facilities.  Interest is capitalized during theconstruction period.  Depreciable useful lives are as follows:

 
| Land improvements               |   | 15 Years     |   |
|---------------------------------|--------|--------------|--------|
| Plant building and  equipment   |   | 7 - 40 Years |   |
| Vehicles and equipment          |   | 5 - 7 Years  |   |
| Office buildings and  equipment |   | 3 - 40 Years |   |

 

F-11

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Table of Contents

 

**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to ConsolidatedFinancial Statements

 

October 31, 2009 and2008

 

*Long-Lived Assets*

 

The Company reviews property and equipment and otherlong-lived assets for impairment whenever events or changes in circumstancesindicate that the carrying amount may not be recoverable.  Circumstanceswhich could trigger a review include, but are not limited to: significantdecreases in the market price of the asset; significant adverse changes in thebusiness climate or legal factors; accumulation of costs significantly inexcess of the amount originally expected for the acquisition of construction ofthe asset; current period cash flow or operating losses combined with a historyof losses or a forecast of continuing losses associated with the use of theassets; and current expectation that the asset will more likely than not besold or disposed significantly before the end of its estimated usefullife.  If circumstances require along-lived asset be tested for possible impairment, the Company first comparesundiscounted cash flows expected to be generated by an asset to the carryingvalue of the asset. If the carrying value of the long-lived asset is notrecoverable on an undiscounted cash flow basis, an impairment is recognized tothe extent that the carrying value exceeds its fair value. Fair value isdetermined through various valuation techniques including discounted cash flowmodels, quoted market values and third-party independent appraisals, asconsidered necessary.

 

The Company’s ethanol production facilities, has aninstalled capacity of 50 million gallons per year.  The carrying value of these facilities at October 31,2009 was approximately $98.5 million. In accordance with the Company’spolicy for evaluating impairment of long-lived assets described above,management has evaluated the recoverability of the facilities based onprojected future cash flows from operations over the facilities’ estimateduseful lives. Management has determined that the projected future undiscountedcash flows from operations of these facilities exceed their carrying value at October 31,2009; therefore, no impairment loss was indicated or recognized. In determiningthe projected future undiscounted cash flows, the Company has made significantassumptions concerning the future viability of the ethanol industry, the futureprice of corn in relation to the future price of ethanol and the overall demandin relation to production and supply capacity. Given the uncertainties in the ethanol industry, should management berequired to adjust the carrying value of the facilities at some future point intime, the adjustment could be significant and could significantly impact theCompany’s financial position and results of operations.  No adjustment has been made to thesefinancial statements for this uncertainty.

 

*Deferred Loan Costs*

 

Costs associated with the issuance of the debtdiscussed in Note 9 and 10 are recorded as deferred loan costs, net ofaccumulated amortization.  Loan costs are amortized to operations over theterm of the related debt using the effective interest method. Prior to thecommencement of operations in September 2007, the Company capitalized loancosts with interest costs during the construction of the plant.  Onceoperations commenced, loan cost amortization was expensed.  As explained in Note 10, the Company hasreclassified the long term portion of certain debt to current.  At that time, the Company expensed theremaining unamortized loan costs totaling approximately $445,000 associatedwith this debt.

 

*Grants*

 

The Company recognizes grant proceeds forreimbursement of expenditures incurred upon complying with the conditions ofthe grant.  For reimbursements of incremental expenses (expenses theCompany otherwise would not have incurred had it not been for the grant), thegrant proceeds are recognized as a reduction of the related expense.  Forreimbursements of capital expenditures, the grants are recognized as areduction of the basis of the asset upon complying with the conditions of thegrant.

 

*Financial Instruments*

 

The Company believes the carrying value of cash andequivalents and restricted cash approximate fair value.

 

The Company believes the carrying amount of derivativeinstruments approximates fair value based on quoted prices in activeexchange-traded or over-the-counter markets.

 

The Company believes the carrying amount of the lineof credit and note payable approximates the fair value due to market interestrates and short-term nature of the debt.

 

F-12

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Table of Contents

 

**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to ConsolidatedFinancial Statements

 

October 31, 2009 and2008

 

Due to declining interest rates during 2009 and 2008and having fixed the interest rate on a portion of the debt as noted in Note10, the carrying amount of the long-term debt, based on contractual terms, wasless than the fair value at October 31, 2009 and 2008.  The carryingamount and the fair value of long-term debt are as follows:

 
| ** **                               | ** ** | **Carrying Amount** | ** ** | **Fair Value** | ** ** |
|------------------------------------------|------------|--------------------------|------------|---------------------|------------|
|                                     |       |                     |       |                |       |
| Long-term debt at  October 31, 2009 |       | $                        | 59,999,987 |                | $          | 60,228,760 |   |
| Long-term debt at  October 31, 2008 |       | $                        | 64,914,888 |                | $          | 66,043,522 |   |

 

*Income Taxes*

 

The Company is treated as a partnership for federaland state income tax purposes and generally does not incur income taxes.Instead, its earnings and losses are included in the income tax returns of themembers.  Therefore, no provision or liability for federal or state incometaxes has been included in these financial statements.  Differencesbetween financial statement basis of assets and tax basis of assets is relatedto capitalization and amortization of organization and start-up costs for taxpurposes, whereas these costs are expensed for financial statement purposes. Inaddition, the Company uses the alternative depreciation system (ADS) for taxdepreciation instead of the straight-line method that is used for bookdepreciation, which also causes temporary differences.  The Company’s tax yearend is December 31.  Primarily dueto the partnership tax status, the Company does not have any significant taxuncertainties that would require disclosure.

 

*Net Income (Loss) per Unit*

 

Basic net income (loss) per unit is computed bydividing net income (loss) by the weighted average number of members’ unitsoutstanding during the period.  Diluted net income or loss per unit iscomputed by dividing net income (loss) by the weighted average number ofmembers’ units and members’ unit equivalents outstanding during the period.

 

F-13

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Table of Contents

 

**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to ConsolidatedFinancial Statements

 

October 31, 2009 and2008

 

*Environmental Liabilities*

 

The Company’s operations are subject to environmentallaws and regulations adopted by various governmental entities in thejurisdiction in which it operates.  These laws require the Company toinvestigate and remediate the effects of the release or disposal of materialsat its location.  Accordingly, the Company has adopted policies,practices, and procedures in the areas of pollution control, occupationalhealth, and the production, handling, storage and use of hazardous materials toprevent material environmental or other damage, and to limit the financialliability, which could result from such events.  Environmental liabilitiesare recorded when the liability is probable and the costs can be reasonablyestimated.

 

*Subsequent Events*

 

The Company has evaluated subsequent events through January 29,2010 the date which the financial statements were issued.

 

F-14

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Table of Contents

 

**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to ConsolidatedFinancial Statements

 

October 31, 2009 and2008

 

**2. GOING CONCERN**

 

The financial statements have been prepared on agoing-concern basis, which contemplates the recoverability of assets and thesatisfaction of liabilities in the normal course of business. Significantvolatility in the commodity markets have caused margins in the ethanol industryto be negative. For  fiscal 2009 theCompany incurred a loss of approximately $11.3 million and used cash ofapproximately $8.3 million for operating activities during the twelve monthsended October 31, 2009.  At October 31,2009, the Company was out of compliance with the minimum working capital, theminimum tangible net worth and the minimum fixed charge ratio provisions of itsmaster loan agreement with AgStar Financial Services, PCA  (“AgStar”). In addition, the Companyanticipates that one or more of the covenants will not be met as of fiscal yearend 2010 unless amended. At January 31, 2009, the Company reclassified thelong-term debt related to this agreement to current liabilities because theCompany was not in compliance with the minimum working capital requirement.That reclassification remains as of October 31, 2009 because of the actualand anticipated covenant defaults stated above. As a result, the Companyexpensed the remaining unamortized loan costs totaling approximately $445,000associated with this debt during the quarter ended January 31, 2009.  If AgStar exercises its right to acceleratethe maturity of the debt outstanding under the master loan agreement or theline of credit, the Company will not have adequate available cash to repay theamounts currently outstanding at October 31, 2009.  Further, while an event of default exists,the Company is not permitted to borrow additional funds under its line ofcredit or revolving term note without AgStar’s consent. These factors raisesubstantial doubt about the Company’s ability to continue as a going concern.

 

On June 12, 2009,the Company and AgStar agreed upon the terms of the renewal of the Company’sline of credit effective May 29, 2009. Therefore, effective May 29, 2009, the Company entered into anAmendment No. 3 to the Fifth Supplement (the “Amendment”) to its masterloan agreement, as previously amended and supplemented, with AgStar.  Among other things, the effect of thisamendment was to renew the Company’s revolving line of credit loan at a maximumcommitment of $6,750,000 and a maturity date of November 1, 2009.  In connection with the renewal, AgStar alsowaived the Company’s noncompliance with the working capital covenant of themaster loan agreement as of and for the periods ending January 31, 2009and April 30, 2009.  AgStar alsowaived excess cash flow payment provisions for the year ended October 31,2008 in consideration of an excess cash flow payment by the Company of $94,700on June 12, 2009.  The balance dueof the October 31, 2008 excess cash flow payment in the amount of$1,799,300 is deferred until such time as the Company makes a request to theLender for certain distributions to its members.  On September 9, 2009, AgStar waived theCompany’s noncompliance with the working capital covenant of the master loanagreement for the period ended July 31, 2009.  Effective December 8, 2009, the Companyand AgStar agreed upon the terms of Amendment No 4 to the Fifth Supplement(“Amendment 4”) to its master loan agreement as previously amended andsupplemented.  The effect of thisAmendment 4 was to extend the maturity date of the revolving line of credit to February 1,2010.  The Company is activelynegotiating the extension of this with the bank.

 

The Company believes it has sufficient capitalresources through October 31, 2010 based upon its current cash reserves,inventory sales, anticipated revenues and the available borrowing under themaster loan agreement, as well as the effect of expense reduction measures,provided that AgStar extends the maturity date of the revolving line of credit,does not exercise its right to accelerate the maturity of the long term debt,and the Company is not otherwise required to repay its indebtedness to AgStarunder the master loan agreement on an accelerated basis. The Company’s expensereduction measures and cash conservation measures include utilizing andreducing corn inventory as well as reducing operating expenses through costcontrols.  If the current industryconditions continue and the Company is not able to maintain sufficient fundingin the short-term, the Company may be forced to raise additional capitalthrough subordinated debt, if available, sell additional equity, restructure orsignificantly curtail its operations, file for bankruptcy or ceaseoperations.  The financial statements donot include any adjustments relating to the recoverability and classificationof recorded asset amounts or amounts and classification of liabilities thatmight be necessary should the Company be forced to take any such actions*.*

 

**3.   UNCERTAINTIES**

 

The Company has certain risks and uncertainties thatit experienced during volatile market conditions such as what the Companyexperienced during fiscal 2008 and 2009. These volatilities can have a severe impact on operations. The Company’srevenues are derived from the sale and distribution of ethanol and distillersgrains to customers primarily located in the U.S. Corn for the productionprocess is supplied to the plant primarily from local agricultural producers.  Ethanol sales average 75% - 80% of totalrevenues and corn costs average 65% - 70% of cost of goods sold.

 

The Company’s operating and financial performance islargely driven by the prices at which it sells ethanol and the net expense ofcorn. The price of ethanol is influenced by factors such as supply and demand,the weather, government policies and programs, unleaded gasoline prices and thepetroleum markets as a whole, although since 2005 the prices of ethanol andgasoline began a divergence with ethanol selling for less than gasoline at thewholesale level. Excess ethanol supply in the market, in particular, putsdownward pressure on the price of ethanol. The largest cost of production iscorn. The cost of corn is generally impacted by factors such as supply anddemand, the weather, government policies and programs, and a risk managementprogram used to protect against the price volatility of these commodities.Market fluctuations in the price of and demand for these products may have asignificant adverse effect on the Company’s operations, profitability and theavailability and adequacy of cash flow to meet the Company’s working capitalrequirements.

 

**4. FAIRVALUE MEASUREMENTS**

 

TheCompany measures certain financial instruments at fair value in our balancesheets.  The fair value of theseinstruments is based on valuations that include inputs that can be classifiedwithin one of the three levels of a hierarchy. Level 1 inputs include quoted market prices in an active market foridentical assets or liabilities.  Level 2inputs are market data, other than Level 1, that are observable either directlyor indirectly.  Level 2 inputs includequoted market prices for similar assets or liabilities, quoted market prices inan inactive market, and other observable information that can be corroboratedby market data.  Level 3 inputs areunobservable and corroborated by little or no market data.  Except for those assets and liabilities whichare required by authoritative accounting guidance to be recorded at fair valuein our balance sheets, the Company has elected not to record any other assetsor liabilities at fair value.  The fairvalue of certain long-lived assets is based on recoverability throughutilization in operations.  Except forthose assets and liabilities which are required by authoritative accountingguidance to be recorded at fair value in our balance sheets, the Company haselected not to record any other assets or liabilities at fair value.

 

Thefollowing table provides information on those assets measured at fair value ona recurring basis.

 
| ** **                       | ** ** | **Fair Value as of**      | ** ** | **Fair Value Measurement Using** | ** ** |
|----------------------------------|------------|---------------------------|------------|----------------------------------|------------|
| ** **                       | ** ** | **October 31, 2009** | ** ** | **Level 1**                      | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Restricted cash — current   |       | $                         | 340,644    |                             | $          | 340,644 |   | $ | — |   | $ | — |   |
| Restricted cash — long-term |       | $                         | 718,790    |                             | $          | 718,790 |   | $ | — |   | $ | — |   |

 

Thefair value of the money market funds included in restricted cash is based onquoted market prices in an active market.

 

**5.  CONCENTRATIONS**

 

The Company sells all of the ethanol and distillergrains produced to two customers under marketing agreements as described inNote 15.  At October 31, 2009 and 2008, these two customers comprised96% and 93% of accounts receivable, respectively.

 

F-15

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Table of Contents

 

**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to ConsolidatedFinancial Statements

 

October 31, 2009 and2008

 

**6.   INVENTORY**

 

Inventory consists of the following at October 31:

 
| ** **      | ** ** | **2009** | ** ** | **2008**  | ** ** |
|-----------------|------------|----------|------------|-----------|------------|
|            |       |     |       |      |       |
| Raw materials   |       | $        | 1,551,255  |      | $          | 5,830,477 |   |
| Work in process |       | 776,801  |       | 1,200,242 |       |
| Finished goods  |       | 800,915  |       | 725,365   |       |
| Supplies        |       | 847,289  |       | 683,007   |       |
| Other grains    |       | 775,857  |       | 1,194,658 |       |
| Totals          |       | $        | 4,752,117  |      | $          | 9,633,749 |   |

 

The Company recorded losses of approximately $352,000and $1,628,000 for the fiscal years ended October 31, 2009 and 2008respectively, related to inventory, in addition to losses recorded on forwardpurchase contracts as noted in Note 15, where the market value was less thanthe cost basis, attributable primarily to decreases in market prices of cornand ethanol. The loss was recorded with the lower of cost or market adjustmentin the statement of operations. In addition, the Company stored grain inventoryfor farmers.  The value of these inventories owned by others isapproximately $283,000 and $658,000 based on market prices at October 31,2009 and 2008, respectively, and is not included in the amounts above..

 

**7. DERIVATIVE INSTRUMENTS**

 

As of October 31, 2009, the Company held nopositions in corn or ethanol derivative instruments.  As of October 31, 2008, the Companyrecorded an asset for derivative instruments of approximately $750,000 at fairvalue in the Consolidated Balance Sheet.

 

The following tables provide details regarding thegains and (losses) from the Company’s derivative instruments in statementsof operations, none of which are designated as hedging instruments:

 
| ** **        | ** ** | **Statement of**        | ** ** | **Twelve Months Ended October 31,** | ** ** |
|-------------------|------------|------------------------------|------------|---------------------------------------------------------|------------|
| ** **        | ** ** | **Operations location** | ** ** | **2009**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
| Corn contracts    |       | Cost of goods sold           |       | $                                                       | 1,207,000  |   | $ | 6,287,000 |   | $ | (2,654,000 | ) |
| Ethanol contracts |       | Revenues                     |       | 373,000                                                 |       | 3,600,000 |   | — |   |
| Totals            |       |                         |       | $                                                       | 1,580,000  |   | $ | 9,887,000 |   | $ | (2,654,000 | ) |

 

**8. CONSTRUCTION IN PROGRESS**

 

The Company capitalizes construction costs andconstruction period interest until the assets are placed in service. Duringfiscal 2007, the Company capitalized interest during the construction period ofapproximately $2,901,000.

 

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Table of Contents

 

**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to ConsolidatedFinancial Statements

 

October 31, 2009 and2008

 

**9.  LINE OF CREDIT**

 

The Company has a line of credit with AgStar subjectto certain borrowing base requirements. On June 12, 2009 and effective May 29, 2009, the Companyentered into an Amendment No. 3 to the Fifth Supplement (the “Amendment”)to its master loan agreement, as previously amended and supplemented, withAgStar.  Among other things, the effect ofthis amendment was to renew the Company’s revolving line of credit loan at amaximum commitment of $6,750,000 and a maturity date of November 1,2009.   AgStar waived the Company’snoncompliance with the working capital covenant of the master loan agreement asof and for the periods ending January 31, 2009, April 30, 2009, and July 31,2009.  Effective December 8, 2009,the Company and AgStar agreed upon the terms of Amendment No 4 to the FifthSupplement (“Amendment 4”) to its master loan agreement as previously amendedand supplemented.  The effect of thisAmendment 4 was to extend the maturity date of the revolving line of credit to February 1,2010.    Interest accrues on borrowingsat the one-month LIBOR plus 3.25%, which totaled 3.49% at October 31, 2009and 5.74% at October 31, 2008. From May 1, 2009 through May 29,2009, AgStar added a 2.0% surcharge to the interest rate on the outstandingamounts under the Company’s master loan agreement.  The Company has a .25% commitment fee on theunused portion of the line of credit. Amounts available under the line ofcredit are reduced by outstanding standby letters of credit.  As of October 31,2009, the Company had drawn $5,000,000 on the line. There was no balanceoutstanding on the line of credit at October 31, 2008.  The Company had outstanding standby lettersof credit of $400,000 at October 31, 2008, which expired in November 2008.  As of October 31, 2009, the Company wasnot in compliance with the minimum working capital, minimum tangible net worthand minimum fixed charge ratio provisions of the master loan agreement.    If AgStar exercises its right toaccelerate the maturity of the debt outstanding under the master loan agreementor the line of credit, the Company will not have adequate available cash torepay the amounts currently outstanding at October 31, 2009.  Further, while an event of default exists,the Company is not permitted to borrow additional funds under its line ofcredit or revolving term note without AgStar’s consent.

 

The line of credit and the term note and revolvingterm note discussed in Note 10 are subject to a general security agreement withthe lending institution bank.  The terms of this agreement require theCompany to maintain certain financial ratios and covenants such as workingcapital and net worth requirements, minimum debt to equity and debt servicecoverage, and restrictions on distributions.  Borrowings under theagreement are secured by substantially all corporate assets.  Duringfiscal 2008, the Company was not in compliance with the debt covenant relatedto the submission of quarterly financial statements within 30 days duringfiscal 2008.  The lender waived compliance for these violations.

 

**10.  LONG-TERM DEBT**

 

Long-term debt consists of the following:

 
| ** **                                                                                                                                                                   | ** ** | **October 31** | ** ** | **October 31** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                                                                                                                                                                   | ** ** | **2009**            | ** ** | **2008**            | ** ** |
|                                                                                                                                                                         |       |                |       |                |       |
| Term note payable to  lending institution, see terms below.                                                                                                                  |       | $                   | 53,381,697 |                | $          | 57,508,968 |   |
|                                                                                                                                                                         |       |                |       |                |       |
| Revolving term note  payable to lending institution, see terms below.                                                                                                        |       | 1,155,872           |       | 1,155,872           |       |
|                                                                                                                                                                         |       |                |       |                |       |
| Note payable to Jackson  County with interest at 4.00%, forgiven during fiscal 2009 based upon job  creation thresholds at specified wages as part of the plant development. |       | —              |       | 100,000             |       |
|                                                                                                                                                                         |       |                |       |                |       |
| Balance forward                                                                                                                                                              |       | $                   | 54,537,569 |                | $          | 58,764,840 |   |

 

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Table of Contents

 

**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to ConsolidatedFinancial Statements

 

October 31, 2009 and2008

 
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                            | ** ** | **October 31** | ** ** | **October 31** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                            | ** ** | **2009**            | ** ** | **2008**            | ** ** |
| Balance from previous  page                                                                                                                                                                                                                                                                                                                                                                                                           |       | $                   | 54,537,569 |                | $          | 58,764,840 |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                |       |                |       |
| Assessment payable as  part of water treatment agreement, due in semi-annual installments of  $189,393 with interest at 6.55%, enforceable by statutory lien, with the  final payment due in 2021. The Company is required to make deposits over 24  months, which began in January 2007, for one years’ worth of debt  service payments that are held on deposit to be applied with the final  payments of the assessment. |       | 3,010,998           |       | 3,173,624           |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                |       |                |       |
| Assessment payable as  part of water treatment agreement, due in semi-annual installments of $25,692  with interest at 0.50%, enforceable by statutory lien, with the final payment  due in 2016.                                                                                                                                                                                                                                     |       | 352,610             |       | 401,985             |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                |       |                |       |
| Assessment payable as  part of water supply agreement, due in monthly installments of $4,126 with  interest at 8.73%, enforceable by statutory lien, with the final payment due  in 2019.                                                                                                                                                                                                                                             |       | 313,520             |       | 334,657             |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                |       |                |       |
| Note payable for  equipment, with monthly payments of $2,371 including effective interest of  6.345%, due in April 2012, secured by equipment.                                                                                                                                                                                                                                                                                   |       | 65,517              |       | 65,956              |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                |       |                |       |
| Note payable to  electrical provider, with monthly payments of $29,775 including implicit  interest of 1.50%, due in December 2013, secured by equipment and  restricted cash.                                                                                                                                                                                                                                                   |       | 1,126,023           |       | 1,573,826           |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                |       |                |       |
| Note payable to  electrical company with monthly payments beginning in October 2009 of  $6,250 with a 1% maintenance fee due each October, due September 2017.  The electrical company is a member of the Company.                                                                                                                                                                                                          |       | 593,750             |       | 600,000             |       |
| Totals                                                                                                                                                                                                                                                                                                                                                                                                                                |       | 59,999,987          |       | 64,914,888          |       |
| Less amounts due within  one year                                                                                                                                                                                                                                                                                                                                                                                                     |       | 55,224,183          |       | 5,649,354           |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                |       |                |       |
| Net long-term debt                                                                                                                                                                                                                                                                                                                                                                                                                    |       | $                   | 4,775,804  |                | $          | 59,265,534 |   |

 

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Table of Contents

 

**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to ConsolidatedFinancial Statements

 

October 31, 2009 and2008

 

* Term Note Payable*

 

The term note requires monthly payments ofapproximately $640,000 of principal and interest. Interest accrues at theone-month LIBOR plus 3.25%, which totaled 3.49% and 5.74% at October 31,2009 and 2008, respectively. In May 2008, the Company locked in aninterest rate of 3.58% plus 3.00%, which totals 6.58% on $45,000,000 of thenote, for three years ending April 30, 2011. As described in Notes 2 and9, as of October 31, 2009, July 31, 2009, April 30, 2009 and January 31,2009 the Company was not in compliance with the covenants of the master loanagreement.  The Company received a waiverfrom AgStar as of and for the periods ended January 31, 2009, April 30,2009 and July 31, 2009.  However,the Company was not in compliance as of October 31, 2009 and does notexpect to be in compliance with one or more covenants of the master loanagreement as of October 31, 2010 unless the covenants are amended.  Therefore, the term note and the revolvingterm note described below have been classified as current liabilities. The termnote originally had a ten year amortization, with a final balloon payment duein October 2012. In addition, the Company is required to make additionalpayments on the term note of excess cash flow, as defined in the agreement, upto $2,000,000 per year to AgStar until the Company meets a specified financialratio. As part of the debt financing, the premium above LIBOR may be reducedbased on the ratio of members’ equity to assets. The owner of the generalcontractor, who is a member, has personally guaranteed up to $3,740,000 of theCompany’s obligations under the master loan agreement.  From May 1, 2009 through May 29,2009, AgStar added a 2.0% surcharge to the interest rate on the outstandingamounts under the Company’s master loan agreement.  If AgStar exercises its right to acceleratethe maturity of the debt outstanding under the master loan agreement or theline of credit, the Company will not have adequate available cash to repay theamounts currently outstanding at October 31, 2009.  Further, while an event of default exists,the Company is not permitted to borrow additional funds under its line ofcredit or revolving term note without AgStar’s consent.

 

 *RevolvingTerm Note*

 

The Company has a revolving term note with AgStar forup to $5,000,000 for cash and inventory management purposes. The maximum amountavailable under the revolving term note decreases $500,000 each year and was$4,000,000 as of October 31, 2009. The Company pays interest on principal advances monthly at the one-monthLIBOR rate plus 3.25%, which totaled 3.49% and 5.74% at October 31, 2009and 2008 respectively. The Company pays a commitment fee of 0.35% per annum onthe unused portion of the revolving term note. As described above and in Note 2and 9, as of and for the period ending October 31, 2009, the Company wasout of compliance with the master loan agreement and does not anticipate beingin compliance as of and for the period ending October 31, 2010.  As such, amounts due under the revolving termnote have been classified as current liabilities.  From May 1, 2009 through May 29,2009, AgStar added a 2.0% surcharge to the interest rate on the outstandingamounts under the Company’s master loan agreement.   During fiscal 2008, the Company was not incompliance with the debt covenant related to the submission of quarterlyfinancial statements within 30 days.  The lender waived compliance forthis violation.

 

Estimated maturities of long-term debt at October 31,2009 are as follows:

 
| 2010                 |   | $         | 55,224,183 |   |
|----------------------|--------|-----------|------------|--------|
| 2011                 |   | 707,088   |       |
| 2012                 |   | 714,147   |       |
| 2013                 |   | 453,477   |       |
| 2014                 |   | 381,599   |       |
| After 2014           |   | 2,519,493 |       |
|                 |   |           |       |
| Total long-term debt |   | $         | 59,999,987 |   |

 

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Table of Contents

 

**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to ConsolidatedFinancial Statements

 

October 31, 2009 and2008

 

**11.  MEMBERS’ EQUITY**

 

The Company is authorized to issue 50,000,000 capitalunits, of which 28,750,000 have been designated Class A units, 11,250,000have been designated as Class B units, and 10,000,000 have not yet beendesignated.  Members of the Company are holders of units who havebeen admitted as members upon their investment in our units and who areadmitted as members by our board of governors.  The minimum number of unitsrequired to retain membership is 2,500 units.  Any holder of units who isnot a member will not have voting rights.  Transferees of units must beapproved by our board of governors to become members.  Members who areholders of our present units are entitled to one vote for each unit held.Subject to the Member Control Agreement, all units share equally in the profitsand losses, distributions of assets, and voting rights on a per unit basis.

 

At October 31, 2009 and 2008, the Company had27,104,625 Class A units issued and outstanding.

 

*Warrants*

 

The Company authorized warrants in fiscal 2004 for25,000 Class A units to the existing nine members of the Board ofGovernors.  The warrants granted to each member of the Board of Governorsthe right to purchase 25,000 Class A units at an exercise price of $.80per unit.  The warrants vested October 31, 2005 and were exercisablefor a period of five years thereafter.  These units were not used in thecomputation of net loss per unit for fiscal 2007 as they would have been anti-dilutive. All of the warrants were exercised in August 2007 whereby the Companyreceived $180,000.

 

**12. LEASES**

 

The Company leases equipment, primarily rail cars,under operating leases through 2017.  Equipment under operating leaseprimarily represents rail cars for which the rentals began in August 2007. Rent expense for fiscal 2009, 2008, and 2007 was approximately $844,000,$853,000, and $225,000 respectively.

 

At October 31, 2009, the Company had thefollowing minimum future lease payments, which at inception had non-cancelableterms of more than one year:

 
| 2010                    |   | $         | 1,660,560  |   |
|-------------------------|--------|-----------|------------|--------|
| 2011                    |   | 1,660,560 |       |
| 2012                    |   | 1,642,705 |       |
| 2013                    |   | 1,556,100 |       |
| 2014                    |   | 1,211,725 |       |
| Thereafter              |   | 2,356,200 |       |
|                    |   |      |       |
| Total lease commitments |   | $         | 10,087,850 |   |

 

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Table of Contents

 

**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to ConsolidatedFinancial Statements

 

October 31, 2009 and2008

 

**13. INCOME TAXES**

 

The differences between consolidated financialstatement basis and tax basis of assets are as follows at October 31:

 
| ** **                                                                                  | ** ** | **2009**    | ** **  | **2008**   | ** ** |
|---------------------------------------------------------------------------------------------|------------|-------------|-------------|------------|------------|
|                                                                                        |       |        |        |       |       |
| Consolidated financial  statement basis of assets                                           |       | $           | 113,089,277 |       | $          | 133,400,810 |   |
| Plus: Organization and  start-up costs capitalized                                          |       | 2,037,334   |        | 2,195,063  |       |
| Less: Unrealized gains  on derivatives                                                      |       | —      |        | (678,713   | )          |
| Less: Accumulated tax  depreciation and amortization greater than financial statement basis |       | (12,978,756 | )           | (7,614,210 | )          |
|                                                                                        |       |        |        |       |       |
| Income tax basis of  assets                                                                 |       | $           | 102,147,855 |       | $          | 127,302,950 |   |

 
| ** **                                             | ** ** | **2009**   | ** ** | **2008**   | ** ** |
|--------------------------------------------------------|------------|------------|------------|------------|------------|
|                                                   |       |       |       |       |       |
| Consolidated financial  statement basis of liabilities |       | $          | 73,835,531 |       | $          | 82,817,630 |   |
| Less: Accrued expenses                                 |       | (1,815,975 | )          | (7,635,675 | )          |
|                                                   |       |       |       |       |       |
| Income tax basis of  liabilities                       |       | $          | 72,019,556 |       | $          | 75,181,955 |   |

 

**14. RELATED PARTY TRANSACTIONS**

 

In December 2006, an affiliate of the plantdesign-builder invested an additional $7,500,000 in exchange for 3,750,000 Class Aunits. In July 2007, the Company was advanced approximately $4,203,000from the owner of the general contractor for the purchase of inventory, whichwas repaid in November 2007.

 

 In December 2006, the Company entered intoan agreement with a member to construct an electrical substation forapproximately $1,020,000. In November 2007, the Company obtained a loanfrom this member as described in Note 10.

 

The Company purchased approximately $45,266,000,$47,569,000 and $8,836,000 of corn from members in fiscal 2009, 2008 and 2007,respectively.

 

Please refer to the section titled “Legal Proceedings”following for information on arbitration proceedings between the Company andFagen, Inc., a related party.

 

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Table of Contents

 

**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to ConsolidatedFinancial Statements

 

October 31, 2009 and2008

 

**15. COMMITMENTS AND CONTINGENCIES**

 

*Water Agreements*

 

In October 2003, the Company entered into anindustrial water supply development and distribution agreement with the City ofHeron Lake for 15 years. The Company has the exclusive rights to the first 600gallons per minute of capacity that is available from the well, and providesfor the Company, combined with Minnesota Soybean Processors (MnSP), to approveany other supply contracts that the City may enter into. In consideration, theCompany will pay one half of the City’s water well bond payments of $735,000,plus a 5% administrative fee, totaling approximately $594,000, and operatingcosts, relative to the Company’s water usage, plus a 10% profit. These costswill be paid as water usage fees. The Company recorded an assessment ofapproximately $367,000 with long-term debt as described in Note 10. The Companypays operating and administrative expenses of approximately $12,000 per year.

 

In May 2006, the Company entered into a watertreatment agreement with the City of Heron Lake and Jackson County for 30years. The Company will pay for operating and maintenance costs of the plant inexchange for receiving treated water. In addition, the Company agreed to anassessment for a portion of the capital costs of the water treatment plant. TheCompany recorded assessments with long-term debt of $500,000 and $3,550,000 infiscal 2007 and 2006, respectively, as described in Note 10. The Company paidoperating and maintenance expenses of approximately $370,000 and $307,000 infiscal 2009 and 2008, respectively.

 

*Marketing Agreements*

 

Effective September 30, 2009, the Company enteredinto an ethanol marketing agreement with an unrelated party under which themarketer will purchase, market and re-sell all of the ethanol produced at theCompany’s plant for the three year term of the agreement.  Following thethree year term, the agreement will automatically renew for subsequent yearterms unless either party terminates the agreement 60 days before the end ofthe term.  The Company pays certain expenses and a 1% marketing fee afterexpenses. The Company assumed leases on 125 rail cars for approximately  $980,000 per year until May 2014 as partof the termination of the prior marketing agreement.

 

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Table of Contents

 

**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to ConsolidatedFinancial Statements

 

October 31, 2009 and2008

 

The Company has a distiller’s grain marketingagreement with an unrelated party to purchase all of the Company’s distiller’sgrains. The agreement provides for predetermined formulas for the sale ofdistiller’s grains and solubles. The initial term was for one year afteroperations commenced and was automatically renewed on a monthly basis. Thecontract is terminable with 90 days written notice.

 

*Legal Proceedings*

 

Permit Matters

 

Our business subjects us to various federal, state andlocal environmental laws and regulations, including those relating todischarges into the air, water and ground; the generation, storage, handling,use, transportation and disposal of hazardous materials; and the health andsafety of our employees.

 

The costsassociated with obtaining these permits and meeting the demands of regulatorsreflected in the permits have increased our costs of construction andproduction. In particular, we have incurred additional costs relating to anair-emission permit from the Minnesota Pollution Control Agency (“MPCA”). Weapplied for a synthetic minor air-emissions source permit in July 2004that was granted by the MPCA in May 2005. In June 2005, a coalitionof two environmental groups and one energy group challenged the grant of thisair emissions permit by an appeal to the Minnesota Court of Appeals. In July 2006,the Minnesota Court of Appeals affirmed the MPCA’s issuance of the permit. Inconjunction with the permit and the permit dispute and to prevent furtherappeals by the coalition, we entered into a compliance agreement with the MPCAon January 23, 2007 that currently governs the air emissions from ourplant. Under the compliance agreement, we agreed to submit an amendment to ourair permit to qualify our facility as a “major emissions source”. Thecompliance agreement also allowed us to continue the construction of ourfacility. Under the compliance agreement, we agreed to operate our facility ina manner such that the emissions of each of the criteria pollutants generatedby our ethanol plant, as determined on a 12 month rolling sum, do not exceed 95tons per year and agreed to comply in all other respects with the air emissionspermit previously issued by the MPCA. Accordingly, we submitted a majoramendment to our existing air-emissions permit in December 2008, and,following air pollution control device testing, we submitted a second majoramendment in September 2009, both seeking amendments to our air permit,including amendments to permit conditions and adjustments to other componentsof plant operations and production.  However, we are continuing discussions with the MPCA regarding thenecessity for qualifying our facility as a major emissions source, particularlyin light of changes in federal law that increased the limit of certainemissions allowed as a synthetic minor source. On March 13, 2008, MPCA issued anotice of violation to us for violations of certain rules, statutes, and permitconditions (as modified by the compliance agreement), including emissionviolations and reporting violations.  Aspart of our continuing discussions with MPCA, we are seeking to resolve theseviolations by agreement with MPCA.  Aviolation of environmental laws, regulations or permit conditions can result insubstantial civil fines or criminal sanctions, or permit revocations or plantshutdown.  Pending the resolution of thisair permit issue, we continue to operate subject to the compliance agreement.

 

Fagen Design-BuildLitigation

 

On September 28,2005, the Company executed a Design-Build Agreement with Fagen, Inc. bywhich Fagen, Inc. agreed to design and build a 50 million gallon per yearcoal-fired ethanol plant in Heron Lake, Minnesota, for a contract price ofapproximately $76,000,000.  The agreementcontained numerous warranty and guarantee provisions as well as a liquidateddamages provision.  Construction began inlate 2005, and after several delays the first corn grind took place on September 21,2007.  The plant, however, has not beenable to meet the air emissions warranties or operate as a “synthetic minorsource” as warranted and intended under the design-build agreement.

 

By the terms of theDesign-Build Agreement, claims or controversies between the Company and Fagen, Inc.arising out of or relating to the Design-Build Agreement, or the breachthereof, are ultimately to be decided by Arbitration in accordance with theConstruction Industry Arbitration Rules of the American ArbitrationAssociation.  On September 18, 2009the Company served and filed its Demand for Arbitration and Request forMediation.  A Revised Demand forArbitration was served and filed on December 23, 2009 following anunsuccessful attempt to mediate the dispute. In these Demands for Arbitration, the Company alleges that Fagen, Inc.breached the terms and conditions of the Design-Build Agreement including itswarranties and guarantees, was negligent in its efforts to correct variousperformance and emissions problems, had not completed the plant on a timelybasis in accordance with the Design-Build Agreement, and prior to the executionof the Agreement had made certain negligent misrepresentations with respect tocoal-fired ethanol plants.  In the Demandfor Arbitration, the Company seeks damages for breach of contract and breach ofthe warranties and guarantees, damages resulting from the negligent efforts tocorrect the problems, damages for the negligent misrepresentations, as well asliquidated damages for delays in the plant construction.  The Company seeks damages in the amount of$22,800,000.

 

Fagen, Inc.responded to the Demand for Arbitration by denying liability and asserting variousaffirmative defenses.  In addition, Fagen, Inc.brought a Counterclaim alleging that it is entitled to payment of a retainageheld by the Company in the amount of approximately $3.8 million.  In addition, Fagen, Inc. alleges that itperformed additional work and provided additional labor and materials to theplant in the amount of approximately $2.2 million; it alleges that this did notconstitute warranty or guarantee work and therefore it claims it is entitled topayment of this additional amount.   TheCompany responded to the Counterclaim by denying the allegations and assertingvarious affirmative defenses. On January 4, 2010,Fagen, Inc. requested to join ICM, Inc. as a party to the arbitrationaction, claiming that joinder was necessary for proper resolution of the claimsand defenses in the arbitration action. On January 27, 2010, ICM, Inc. responded to the request,agreeing to be joined provided certain procedures are established.  In its response, ICM also indicated that itintends to assert claims against us under the license agreement we entered intowith ICM as part of the design build agreement with Fagen.  On January 27, 2010, we filed ourresponse and objections to Fagen’s request to join ICM as a party, andrequested that a special arbitrator be appointed to resolve the joinderissues.  We intend to defend against theFagen counterclaims and any claims brought by ICM, Inc. and assert ourdefenses vigorously.

 

The arbitrationproceeding is in its early phase, and arbitrators have not yet been selected.

 

F-23

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Table of Contents

 

**HERONLAKE BIOENERGY, LLC AND SUBSIDIARY**

 

Notes to ConsolidatedFinancial Statements

 

October 31, 2009 and2008

 

*Contractual Obligations*

 

The following table provides information regarding theconsolidated contractual obligations of the Company as of October 31,2009:

 
| ** **                      | ** ** | **Total**  | ** **  | **Less than  One Year** | ** ** | **One to Three  Years** | ** ** | **Three to  Five Years** | ** ** | **Greater  Than Five  Years** | ** ** |
|---------------------------------|------------|------------|-------------|-----------------------------------|------------|-----------------------------------|------------|------------------------------------|------------|------------------------------------|------------|
| Long-term debt  obligations (1) |       | $          | 70,748,224  |                              | $          | 64,521,802                        |       | $                                  | 1,844,976  |                               | $          | 1,198,130 |   | $ | 3,183,316 |   |
| Operating lease  obligations    |       | 10,087,850 |        | 1,660,560                         |       | 3,303,265                         |       | 2,767,825                          |       | 2,356,200                          |       |
| Purchase obligations  (2)       |       | 20,083,737 |        | 12,246,237                        |       | 7,837,500                         |       | —                             |       | —                             |       |
| Total contractual  obligations  |       | $          | 100,919,811 |                              | $          | 78,428,599                        |       | 12,985,741                         |       | $                                  | 3,965,955  |   | $ | 5,539,516 |   |
|                                 |            |            |             |                                   |            |                                   |            |                                    |            |                                    |            |  |  |  |  |  |

 

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(1)           Long-term debt obligations includeestimated interest and interest on unused debt.

(2)           Purchase obligations primarily includeforward contracts for corn and coal.

 

The Company also has agreements to pay for theoperating costs and maintenance expenses associated with the water agreement ofapproximately $12,000 and $205,000 per year with term lengths of approximately15 and 30 years, respectively.

 

The Company has coal supply agreements with a minimumcommitment of approximately $4,950,000 per year until May 2012, includingtransportation, with provisions for fuel surcharges and adjustments forinflation. The amounts related to these agreements are included with purchaseobligations in the table above.

 

*Forward Contracts*

 

The Company has forward contracts in place for cornpurchases of approximately $7.3 million through May 2010, which representsapproximately 9% of the Company’s anticipated purchases in fiscal 2010.

 

Currently, some of these corn contract prices areabove current market prices for corn. Given the recent changing price of cornupon taking delivery under these contracts, the Company would incur a loss. Accordingly,the Company recorded a loss on purchase commitments of approximately $5,056,000and $7,123,000 for the twelve months ended October 31, 2009 and 2008respectively. The loss was recorded as a lower of cost or market adjustment onthe statement of operations. The amount of the loss was determined by applyinga methodology similar to that used in the lower of cost or market evaluationwith respect to inventory. Given the uncertainty of future ethanol prices, thisloss may or may not be recovered, and further losses on the outstandingpurchase commitments could be recorded in future periods.

 

F-24

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Table of Contents

 

**HERONLAKE BIOENERGY, LLC**

 

**INDEX TOEXHIBITS TO FORM 10-K FOR FISCAL YEAR ENDED OCTOBER 31, 2008**

 
| **Exhibit  Number** | ** ** | **Exhibit Title** | ** **                                                                                                                                                                                                                             | **Incorporated by Reference To:** |
|---------------------|------------|------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------------------------------------------|
|                |       |                   |                                                                                                                                                                                                                                   |                                             |
| 3.1                 |       |                   | First Amended and Restated Articles of Organization  of Heron Lake BioEnergy, LLC                                                                                                                                                      |                                             | Exhibit 3.1 of the Company’s Registration  Statement on Form 10 (SEC Accession No. 0001104659-08-054557) filed  on August 22, 2008 (the “2008 Registration Statement”). |
| 3.2                 |       |                   | Member Control Agreement of Heron Lake BioEnergy,  LLC, as amended through March 29, 2008                                                                                                                                         |                                             | Exhibit 3.2 of the Company’s 2008 Registration  Statement. |
| 4.1                 |       |                   | Form of Class A Unit Certificate                                                                                                                                                                                             |                                             | Exhibit 4.1 of the Company’s 2008 Registration  Statement. |
| 4.2                 |       |                   | Unit Transfer Policy adopted November 5, 2008                                                                                                                                                                                     |                                             | Exhibit 4.1 of the Company’s Current Report on  Form 8-K dated November 5, 2008. |
| 10.1                |       |                   | Fourth Amended and Restated Loan Agreement dated  October 1, 2007 by and between AgStar Financial Services, PCA and Heron  Lake BioEnergy, LLC                                                                                    |                                             | Exhibit 10.1 of the Company’s 2008 Registration  Statement. |
| 10.2                |       |                   | Third Supplement dated October 1, 2007 to  Fourth Amended and Restated Loan Agreement by and between AgStar Financial  Services, PCA and Heron Lake BioEnergy, LLC                                                                |                                             | Exhibit 10.2 of the Company’s 2008 Registration  Statement. |
| 10.3                |       |                   | Fourth Supplement dated October 1, 2007 to  Fourth Amended and Restated Loan Agreement by and between AgStar Financial  Services, PCA and Heron Lake BioEnergy, LLC                                                               |                                             | Exhibit 10.3 of the Company’s 2008 Registration  Statement. |
| 10.4                |       |                   | Term Note dated October 1, 2007 in principal  amount of $59,583,000 by Heron Lake BioEnergy, LLC to AgStar Financial  Services, PCA as lender                                                                                     |                                             | Exhibit 10.4 of the Company’s 2008 Registration  Statement. |
| 10.5                |       |                   | Term Revolving Note dated October 1, 2007 in  principal amount of $5,000,000 by Heron Lake BioEnergy, LLC to AgStar Financial  Services, PCA as lender                                                                            |                                             | Exhibit 10.5 of the Company’s 2008 Registration  Statement. |
| 10.6                |       |                   | Personal Guaranty dated October 1, 2007 by  Roland Fagen, guarantor, in favor of AgStar Financial Services, PCA                                                                                                                   |                                             | Exhibit 10.6 of the Company’s 2008 Registration  Statement. |
| 10.7                |       |                   | Fourth Amended and Restated Guaranty dated  October 1, 2007 by Lakefield Farmers Elevator, LLC in favor of AgStar  Financial Services, PCA                                                                                        |                                             | Exhibit 10.7 of the Company’s 2008 Registration  Statement. |
| 10.8                |       |                   | Fifth Supplement dated November 19, 2007 to  Fourth Amended and Restated Loan Agreement by and between AgStar Financial  Services, PCA and Heron Lake BioEnergy, LLC                                                              |                                             | Exhibit 10.8 of the Company’s 2008 Registration  Statement. |
| 10.9                |       |                   | Revolving Line of Credit Note dated  November 19, 2007 in principal amount of $7,500,000 by Heron Lake  BioEnergy, LLC to AgStar Financial Services, PCA as lender                                                                |                                             | Exhibit 10.9 of the Company’s 2008 Registration  Statement. |
| 10.10               |       |                   | Industrial Water Supply Development and Distribution  Agreement dated October 27, 2003 among Heron Lake BioEnergy, LLC (f/k/a  Generation II Ethanol, LLC), City of Heron Lake, Jackson County, and  Minnesota Soybean Processors |                                             | Exhibit 10.10 of the Company’s 2008  Registration Statement. |
| 10.11               |       |                   | Industrial Water Supply Treatment Agreement dated  May 23, 2006 among Heron Lake BioEnergy, LLC, City of Heron Lake and  County of Jackson                                                                                        |                                             | Exhibit 10.11 of the Company’s 2008  Registration Statement. |

 

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Table of Contents

 
| **Exhibit  Number** | ** ** | **Exhibit Title** | ** **                                                                                                                                                                                                   | **Incorporated by Reference To:** |
|---------------------|------------|------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------------------------------------------|
| 10.12               |       |                   | Standard Form of Agreement between Owner and  Designer — Lump Sum dated September 28, 2005 by and between  Fagen, Inc. and Heron Lake BioEnergy, LLC†                               |                                             | Exhibit 10.12 of the Company’s 2008 Registration  Statement. |
| 10.13               |       |                   | Distiller’s Grain Marketing Agreement dated  October 5, 2005 by and between Heron Lake BioEnergy, LLC and Commodity  Specialist Company as assigned to CHS Inc. as of August 17, 2007         |                                             | Exhibit 10.13 of the Company’s 2008 Registration  Statement. |
| 10.14               |       |                   | Ethanol Fuel Marketing Agreement dated  August 7, 2006 by and between RPGM, Inc. and Heron Lake BioEnergy,  LLC                                                                                    |                                             | Exhibit 10.14 of the Company’s 2008  Registration Statement. |
| 10.15               |       |                   | Letter Agreement re: Environmental Compliance Support  dated March 12, 2007 by and between Fagen Engineering, LLC Heron Lake  BioEnergy, LLC                                                            |                                             | Exhibit 10. 15 of the Company’s 2008  Registration Statement. |
| 10.16               |       |                   | Coal Loading, Transport, and Delivery Agreement  effective as of April 1, 2007 by and between Tersteeg Transport Inc. and  Heron Lake BioEnergy, LLC                                                    |                                             | Exhibit 10.16 of the Company’s 2008  Registration Statement. |
| 10.17               |       |                   | Coal Transloading Agreement dated June 1, 2007  by and between Southern Minnesota Beet Sugar Cooperative and Heron Lake  BioEnergy, LLC†                                                           |                                             | Exhibit 10.17 of the Company’s 2008  Registration Statement. |
| 10.18               |       |                   | Master Coal Purchase and Sale Agreement dated  June 1, 2007 by and between Northern Coal Transport Company and Heron  Lake BioEnergy, LLC, including confirmation letter dated July 13, 2007† |                                             | Exhibit 10.18 of the Company’s 2008  Registration Statement. |
| 10.19               |       |                   | Loan Agreement dated December 28, 2007 by and  between Federated Rural Electric Association and Heron Lake BioEnergy, LLC                                                                               |                                             | Exhibit 10.19 of the Company’s 2008  Registration Statement. |
| 10.20               |       |                   | Secured Promissory Note issued December 28,  2007 by Heron Lake BioEnergy, LLC as borrower to Federated Rural Electric  Association as lender in principal amount of $600,000                           |                                             | Exhibit 10.20 of the Company’s 2008  Registration Statement. |
| 10.21               |       |                   | Security Agreement dated December 28, 2007 by  Heron Lake BioEnergy, LLC in favor of Federated Rural Electric Association                                                                               |                                             | Exhibit 10.21 of the Company’s 2008  Registration Statement. |
| 10.22               |       |                   | Electric Service Agreement dated October 17,  2007 by and between Interstate Power and Light Company and Heron Lake  BioEnergy, LLC                                                                     |                                             | Exhibit 10.22 of the Company’s 2008  Registration Statement. |
| 10.23               |       |                   | Shared Savings Contract dated November 16, 2007  by and between Interstate Power and Light Company and Heron Lake BioEnergy,  LLC                                                                       |                                             | Exhibit 10.23 of the Company’s 2008  Registration Statement. |
| 10.24               |       |                   | Escrow Agreement dated November 16, 2007 by and  between Heron Lake BioEnergy, LLC , Farmers State Bank of Hartland for the  benefit of Interstate Power and Light Company                              |                                             | Exhibit 10.24 of the Company’s 2008  Registration Statement. |
| 10.25               |       |                   | Employment Agreement dated February 1, 2008 by  and between Heron Lake BioEnergy, LLC and Robert J. Ferguson *                                                                                          |                                             | Exhibit 10.25 of the Company’s 2008  Registration Statement. |
| 10.26               |       |                   | Services Contract dated March 1, 2007 by and  between Heron Lake BioEnergy, LLC and Gerber & Haugen, P.L.L.P.  relating to the services of James A. Gerber *                                   |                                             | Exhibit 10.26 of the Company’s 2008  Registration Statement. |
| 10.27               |       |                   | Letter Agreement dated February 28, 2008 by and  between Heron Lake BioEnergy, LLC and Gerber & Haugen, P.L.L.P.  relating to the services of James A. Gerber *                                |                                             | Exhibit 10.27 of the Company’s 2008  Registration Statement. |

 

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Table of Contents

 
| **Exhibit  Number** | ** ** | **Exhibit Title** | ** **                                                                                                                                                                     | **Incorporated by Reference To:** |
|---------------------|------------|------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------------------------------------------|
| 10.28               |       |                   | Compliance Agreement effective January 23, 2007  by and between Heron Lake BioEnergy, LLC and the Minnesota Pollution Control  Agency                                     |                                             | Exhibit 10.28 of the Company’s 2008 Registration  Statement. |
| 10.29               |       |                   | Unit Transfer Policy of Heron Lake BioEnergy, LLC  dated November 2008                                                                                                    |                                             | Exhibit 4.1 to Current Report on Form 8-K  dated November 5, 2008. |
| 10.30               |       |                   | Letter Agreement dated November 25, 2008 by and  between Heron Lake BioEnergy, LLC, CFO Systems, LLC and Brett L. Frevert  relating to the services of Brett L. Frevert * |                                             | Exhibit 10.1 to Current Report on Form 8-K  dated November 26, 2008. |
| 10.31               |       |                   | Ethanol Purchase and Marketing Agreement dated  September 2, 2009 by and between Heron Lake BioEnergy, LLC and C&N  Ethanol Marketing Corporation.                    |                                             | Exhibit 10.1 to Current Report on Form 8-K  dated September 2, 2009. |
| 10.32               |       |                   | Amendment No. 4 to Fifth Supplement dated  December 8, 2009 by and between Heron Lake BioEnergy, LLC and AgStar  Financial Services, PCA                             |                                             | Attached hereto. |
|                |       |                   |                                                                                                                                                                           |                                             |   |
| 21.1                |       |                   | Subsidiaries of the Registrant                                                                                                                                                 |                                             | Exhibit 21.2 of the Company’s 2008 Registration  Statement. |
| 31.1                |       |                   | Certification of Chief Executive Officer (principal  executive officer) pursuant to Rules 13a-14(a) and  15d-14(a) of the Exchange Act.                         |                                             | Attached hereto. |
| 31.2                |       |                   | Certifications of Chief Financial Officer (principal  financial officer) pursuant to Rules 13a-14(a) and  15d-14(a) of the Exchange Act.                        |                                             | Attached hereto. |
| 32                  |       |                   | Certification pursuant to 18 U.S.C. § 1350.                                                                                                                               |                                             | Attached hereto. |

 

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| *      |   |   | Indicates compensatory agreement.                                                                                                                                                                                                                                                                                  |
|--------|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| † |   |   | Certain portions of this exhibit have been redacted  and filed on a confidential basis with the Commission pursuant to a request  for confidential treatment under Rule 24b-2 of under the Exchange Act.  Spaces corresponding to the deleted portions are represented by brackets with  asterisks [ * * * ]. |

 

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