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**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

** **

**x****      QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

** **

**For the quarterly period ended June 30, 2010**

** **

**OR**

** **

**o****         TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

** **

**For the transition periodfrom                       to                       **

 

**Commissionfile number: 0-17189**

 

**CALIFORNIACOASTAL COMMUNITIES, INC.**

(Exact name of registrant asspecified in its charter)

 

| **Delaware**                                                    | ** ** | **02-0426634**                       |
|-----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer Identification No.) |
| ** **                                                      | ** ** | ** **                           |
| **6 Executive Circle, Suite 250  Irvine, California**      | ** ** | **92614**                            |
| (Address of principal executive offices)                        |       | (Zip Code)                           |

 

Registrant’s telephonenumber, including area code: **(949) 250-7700**

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.  YES x NO o

 

Indicate by check mark whether the registrant has submittedelectronically and posted on its corporate Web site, if any, every InteractiveData File required to be submitted and posted pursuant to Rule 405 ofRegulation S-T (§232.405 of this chapter) during the preceding 12 months (orfor such shorter period that the registrant was required to submit and postsuch files).  Yes o No o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reporting company. Seedefinitions of “large accelerated filer,” “accelerated filer,” and “smallerreporting company” in Rule 12b-2 of the Exchange Act.

 

| Large  accelerated filer o                     |   | Accelerated  filer  ̈    |
|------------------------------------------------|--------|-----------------------------------|
|                                           |   |                              |
| Non-accelerated  filer o                       |   | Smaller  reporting company x |
| (Do  not check if a smaller reporting company) |   |                              |

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act).  YES o NO x

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date.

 

As of August 2, 2010 there were 10,995,902 shares of Common Stock,par value $.05 outstanding

 

 

 

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**CALIFORNIA COASTAL COMMUNITIES, INC.**

 

**(DEBTOR-IN-POSSESSION)**

 

**FORM 10-Q**

 

**FOR THE QUARTER ENDED JUNE 30, 2010**

 

**INDEX**

 
| Cautionary  Statement About Forward-Looking Statements | 3                       |
|--------------------------------------------------------|-------------------------|
|                                                   |                    |   |   |
| Part I -                                          | Financial  Information: | 5 |
|                                                   |                    |   |   |
|                                                   | Item 1.                 | Consolidated  Financial Statements | 5 |
|                                                   |                    |   |   |
|                                                   |                    | Consolidated  Balance Sheets — June 30, 2010 (unaudited) and December 31, 2009 | 5 |
|                                                   |                    |   |   |
|                                                   |                    | Consolidated  Statements of Operations - Three and Six Months Ended June 30, 2010 and  2009 (unaudited) | 6 |
|                                                   |                    |   |   |
|                                                   |                    | Consolidated  Statements of Cash Flows -Six Months Ended June 30, 2010 and 2009  (unaudited) | 7 |
|                                                   |                    |   |   |
|                                                   |                    | Notes to  Consolidated Financial Statements | 8 |
|                                                   |                    |   |   |
|                                                   | Item 2.                 | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 23 |
|                                                   |                    |   |   |
|                                                   | Item 3.                 | Quantitative  and Qualitative Disclosures About Market Risk | 38 |
|                                                   |                    |   |   |
|                                                   | Item 4.                 | Controls and  Procedures | 39 |
|                                                   |                    |   |   |
| Part II -                                         | Other Information:      | 39 |
|                                                   |                    |   |   |
|                                                   | Item 1.                 | Legal Proceedings | 39 |
|                                                   |                    |   |   |
|                                                   | Item 6.                 | Exhibits | 39 |
|                                                   |                    |   |   |
| SIGNATURE                                              |                    | 40 |

 

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**CAUTIONARYSTATEMENT ABOUT FORWARD-LOOKING STATEMENTS**

 

ThisQuarterly Report on Form 10-Q contains forward-looking statements withinthe meaning of Section 27A of the Securities Exchange Act of 1933 andSection 21E of the Securities Exchange Act of 1934 that relate to futureevents or our future financial performance. In addition, other statements wemay make from time to time, such as press releases, oral statements made by ourofficials and other reports that we file with the Securities and ExchangeCommission may also contain such forward-looking statements. Undue relianceshould not be placed on these statements which involve known and unknown risks,uncertainties and other factors which may cause our actual results, performanceor achievements to be materially different from any future results,performances or achievements expressed or implied by the forward-lookingstatements. In some cases, you can identify forward-looking statements byterminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,”“believes,” “estimates,” “predicts,” “potential,” “continue,” or the negativeof such terms or other comparable terminology.

 

These forward-looking statements include, but are not limited to:

 

·                  the impact,effect and eventual result of the Chapter 11 Cases in refinancing orrestructuring our debt obligations under the Revolving Loan and Term Loan andraising additional capital;

 

·                  our and theother Debtors’ ability to remain as a debtors-in-possession during the pendencyof the Chapter 11 Cases;

 

·                  our ability to createstockholder value;

 

·                  our compliance with futuredebt covenants and actions we may take with respect thereto;

 

·                  economic changes nationallyor in local markets, including changes in consumer confidence, volatility ofmortgage interest rates and inflation;

 

·                  continued or increaseddownturn in the homebuilding industry;

 

·                  statements about ourstrategies, plans, objectives, goals, expectations and intentions;

 

·                  information relating toanticipated operating results, financial resources, changes in revenues,changes in profitability, interest expense, growth and expansion;

 

·                  the impact of demographictrends and supply constraints on the demand for and supply of housing;

 

·                  housing market conditions inthe geographic markets in which we operate;

 

·                  the number and types ofhomes and number of acres of land that we may develop and sell;

 

·                  our ability to deliver homesfrom backlog;

 

·                  the timing and outcomes ofregulatory approval processes or administrative proceedings, which may resultin delays in land entitlement, development, construction, or the opening of newcommunities;

 

·                  our ability to securematerials and subcontractors;

 

·                  our ability to produce theliquidity and capital necessary to service our debt, fund operations, expandand take advantage of future opportunities if current market conditionspersist;

 

·                  our cost of and ability toaccess additional capital;

 

·                  our ability to realize thevalue of our net operating loss carry forwards;

 

·                  our ability to continuerelationships with current or future partners;

 

·                  the effectiveness andadequacy of our disclosure and internal controls;

 

·                  the impact of recentaccounting pronouncements; and

 

·                  stock market valuations.

 

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Any or all of the forward-looking statements included in this reportand in any other reports or public statements made by us may turn out to beinaccurate. This can occur as a result of incorrect assumptions or as aconsequence of known or unknown risks and uncertainties. These risks anduncertainties include the unpredictability of the Chapter 11 bankruptcyprocess; the competitive environment in which we operate; local, regional andnational economic conditions; the effects of the current national credit marketcrisis, inflation and the recession; our ability to comply with the covenantsand amortization schedules contained in our debt facilities after we emergefrom bankruptcy; the demand for homes; adverse market conditions that couldresult in additional inventory impairments, including an oversupply of unsoldhomes, declining home prices, and increased foreclosure and short saleactivity; declines in consumer confidence; increases in competition;fluctuations in interest rates and the availability of mortgage financing;mortgage foreclosure rates; the availability and cost of land for futuregrowth; the availability of capital, including access under our existing creditfacilities; uncertainties and fluctuations in capital and securities markets;changes in tax laws and their interpretation; legal proceedings; the ability ofcustomers to finance the purchase of homes or sell existing homes; theavailability and cost of labor and materials; the amount of our debt and theimpact of restrictive covenants in our loan agreements; adverse weatherconditions; domestic and international political events; geopolitical risks andthe uncertainties created by terrorist attacks; the effects of governmentalregulation, including regulations concerning development of land, the homebuilding industry, sales and customer financing processes, and the environment;and other risks discussed in our filings with the Securities and ExchangeCommission. Many factors mentioned in this report or in other reports or publicstatements made by us, such as government regulation and the competitiveenvironment, will be important in determining our future performance.Consequently, actual results may differ materially from those that might beanticipated from our forward-looking statements. You should not place unduereliance on any of these forward-looking statements because they are based oncurrent expectations or beliefs regarding future events or circumstances, whichinvolve known and unknown risks, uncertainties and other factors which maycause our actual results, performance or achievements to be materiallydifferent from any future results, performances or achievements expressed orimplied by these forward-looking statements.

 

Althoughwe believe that our strategies, plans, objectives, goals, expectations andintentions reflected in, or suggested by these forward-looking statements arereasonable given current information available to us, we can give no assurancethat any of them will be achieved. Forward-looking statements speak only as ofthe date they are made. We undertake no obligation to publicly update anyforward-looking statements, whether as a result of new information, futureevents or otherwise. However, any further disclosures made on related subjectsin our subsequent reports on Forms 10-K, 10-Q and 8-K should be consulted.

 

Theseforward-looking statements should be considered in light of the informationincluded in this report and our other filings with the Securities and ExchangeCommission, including, without limitation, the description of trends and otherfactors in “Management’s Discussion and Analysis of Financial Condition and Resultsof Operations,” set forth in this Form 10-Q and in our Form 10-K forthe year ended December 31, 2009 together with the “Risk Factors” setforth therein. You should also read the following “Consolidated FinancialStatements” and the related notes.

 

Weassume no, and hereby disclaim any, obligation to update any of the foregoingor any other forward-looking statements, whether as a result of newinformation, future events, changed circumstances or any other reason after thedate of this Form 10-Q. We nonetheless reserve the right to make suchupdates from time to time by press release, periodic report or other method ofpublic disclosure without the need for specific reference to thisForm 10-Q or any other report filed by us. No such update shall be deemedto indicate that other statements not addressed by such update remain corrector create an obligation to provide any other updates.

 

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**PART I - FINANCIALINFORMATION**

 

**Item 1.  Financial Statements.**

 

CALIFORNIA COASTAL COMMUNITIES, INC.

 

(DEBTOR-IN-POSSESSION)

 

CONSOLIDATED BALANCE SHEETS

 

(unaudited)

 

(in millions)

 
| ** **                                                                                                | ** ** | **June 30,  2010** | ** ** | **December 31,  2009** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------------|------------|
| ** **                                                                                                | ** ** | ** **         | ** ** | ** **                  | ** ** |
| ASSETS                                                                                                    | ** ** | ** **         | ** ** | ** **                  | ** ** |
| ** **                                                                                                | ** ** | ** **         | ** ** | ** **                  | ** ** |
| Cash and cash equivalents                                                                                 |       | $                  | 6.3        |                        | $          | 8.9 |   |
| Restricted cash                                                                                           |       | 0.8                |       | 0.8                         |       |
| Real estate inventories                                                                                   |       | 232.7              |       | 235.4                       |       |
| Other assets, net                                                                                         |       | 3.2                |       | 4.8                         |       |
|                                                                                                      |       |               |       |                        |       |
|                                                                                                      |       | $                  | 243.0      |                        | $          | 249.9 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                 | ** ** | ** **         | ** ** | ** **                  | ** ** |
| ** **                                                                                                | ** ** | ** **         | ** ** | ** **                  | ** ** |
| Liabilities not subject to compromise:                                                                    |       |               |       |                        |       |
| Accounts payable and accrued liabilities                                                                  |       | $                  | 5.9        |                        | $          | 2.9 |   |
| Model home financing                                                                                      |       | 22.5               |       | 22.5                        |       |
| Other liabilities                                                                                         |       | 0.5                |       | 0.4                         |       |
|                                                                                                      |       |               |       |                        |       |
| Total liabilities not subject to compromise                                                               |       | 28.9               |       | 25.8                        |       |
|                                                                                                      |       |               |       |                        |       |
| Liabilities subject to compromise:                                                                        |       |               |       |                        |       |
| Accounts payable and accrued liabilities                                                                  |       | 1.0                |       | 0.9                         |       |
| Revolving loan                                                                                            |       | 81.7               |       | 81.7                        |       |
| Term loan                                                                                                 |       | 99.8               |       | 99.8                        |       |
| Other liabilities                                                                                         |       | 8.3                |       | 8.3                         |       |
|                                                                                                      |       |               |       |                        |       |
| Total liabilities subject to compromise                                                                   |       | 190.8              |       | 190.7                       |       |
|                                                                                                      |       |               |       |                        |       |
| Commitments and contingencies                                                                             |       |               |       |                        |       |
|                                                                                                      |       |               |       |                        |       |
| Stockholders’ equity:                                                                                |       |               |       |                        |       |
| Common Stock—$.05 par value; 13,500,000 shares  authorized; 10,995,902 shares issued and outstanding |       | 0.5                |       | 0.5                         |       |
| Excess Stock—$.05 par value; 13,500,000 shares  authorized; no shares outstanding                    |       | —             |       | —                      |       |
| Additional paid-in capital                                                                                |       | 59.5               |       | 59.5                        |       |
| Accumulated deficit                                                                                       |       | (34.1              | )          | (24.0                       | )          |
| Accumulated other comprehensive loss, net                                                                 |       | (2.6               | )          | (2.6                        | )          |
| Total stockholders’ equity                                                                           |       | 23.3               |       | 33.4                        |       |
|                                                                                                      |       |               |       |                        |       |
|                                                                                                      |       | $                  | 243.0      |                        | $          | 249.9 |   |

 

See the accompanying notes to Consolidated Financial Statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

(DEBTOR-IN-POSSESSION)

 

CONSOLIDATED STATEMENTS OFOPERATIONS

 

(in millions, except per share amounts)

 

(unaudited)

 
| ** **                                    | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                    | ** ** | **2010**                                        | ** ** | **2009**                                      | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                    | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues:                                     |       |                                            |       |                                          |       |   |   |   |   |
| Homebuilding                                  |       | $                                               | 7.7        |                                          | $          | 10.5 |   | $ | 10.7 |   | $ | 23.3 |   |
| Land sales                                    |       | 1.4                                             |       | —                                        |       | 1.4 |   | — |   |
|                                          |       | 9.1                                             |       | 10.5                                          |       | 12.1 |   | 23.3 |   |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Costs of sales:                               |       |                                            |       |                                          |       |   |   |   |   |
| Homebuilding                                  |       | 7.4                                             |       | 8.6                                           |       | 10.0 |   | 17.4 |   |
| Land sales                                    |       | —                                          |       | —                                        |       | — |   | — |   |
| Loss on impairment of real estate inventories |       | 6.0                                             |       | —                                        |       | 6.0 |   | 3.2 |   |
|                                          |       | 13.4                                            |       | 8.6                                           |       | 16.0 |   | 20.6 |   |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Gross operating (loss) profit                 |       | (4.3                                            | )          | 1.9                                           |       | (3.9 | ) | 2.7 |   |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Selling, general and administrative expenses  |       | 0.8                                             |       | 1.0                                           |       | 2.2 |   | 2.5 |   |
| Reorganization costs                          |       | 2.4                                             |       | —                                        |       | 3.7 |   | — |   |
| Interest expense                              |       | —                                          |       | 0.1                                           |       | — |   | 0.8 |   |
| Gain on debt restructuring                    |       | —                                          |       | —                                        |       | — |   | (20.7 | ) |
| Other expense, net                            |       | 0.2                                             |       | 0.3                                           |       | 0.3 |   | 0.7 |   |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| (Loss) income before income taxes             |       | (7.7                                            | )          | 0.5                                           |       | (10.1 | ) | 19.4 |   |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Income tax expense (benefit)                  |       | —                                          |       | 7.8                                           |       | — |   | 15.5 |   |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Net (loss) income                             |       | $                                               | (7.7       | )                                             | $          | (7.3 | ) | $ | (10.1 | ) | $ | 3.9 |   |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Net (loss) earnings per common share:         |       |                                            |       |                                          |       |   |   |   |   |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Basic and diluted                             |       | $                                               | (0.70      | )                                             | $          | (0.66 | ) | $ | (0.92 | ) | $ | 0.36 |   |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Common equivalent shares:                     |       |                                            |       |                                          |       |   |   |   |   |
|                                          |       |                                            |       |                                          |       |   |   |   |   |
| Basic and diluted                             |       | 11.0                                            |       | 11.0                                          |       | 11.0 |   | 11.0 |   |

 

See the accompanying notes to Consolidated Financial Statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

(DEBTOR-IN-POSSESSION)

 

CONSOLIDATED STATEMENTS OFCASH FLOWS

 

(in millions)

(unaudited)

 
| ** **                                                                       | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                       | ** ** | **2010**                                 | ** ** | **2009** | ** ** |
|                                                                             |       |                                     |       |   |   |
| Cash flows from operating activities:                                            |       |                                     |       |   |   |
| Net (loss) income                                                                |       | $                                        | (10.1      | ) | $ | 3.9 |   |
| Adjustments to reconcile net loss to cash used in  operating activities:         |       |                                     |       |   |   |
| Gain on debt restructuring                                                       |       | —                                   |       | (20.7 | ) |
| Model homes depreciation                                                         |       | 0.1                                      |       | 0.2 |   |
| Deferred taxes                                                                   |       | (3.4                                     | )          | 7.9 |   |
| Deferred tax asset valuation allowance                                           |       | 3.4                                      |       | 7.6 |   |
| Gains on sales of real estate inventories and land                               |       | (2.1                                     | )          | (5.9 | ) |
| Loss on impairment of real estate inventories                                    |       | 6.0                                      |       | 3.2 |   |
| Proceeds from sale of real estate inventories and  land, net                     |       | 11.6                                     |       | 22.6 |   |
| Increase in real estate inventories                                              |       | (11.9                                    | )          | (16.1 | ) |
| Accrued reorganization costs                                                     |       | 1.8                                      |       | — |   |
| Changes in assets and liabilities:                                               |       |                                     |       |   |   |
| Decrease in other assets                                                         |       | 0.7                                      |       | 2.0 |   |
| Increase in accounts payable, accrued and other  liabilities                     |       | 1.3                                      |       | 3.0 |   |
|                                                                             |       |                                     |       |   |   |
| Cash (used in) provided by operating activities                                  |       | (2.6                                     | )          | 7.7 |   |
|                                                                             |       |                                     |       |   |   |
| Cash flows from investing activities:                                            |       |                                     |       |   |   |
| Change in restricted cash                                                        |       | —                                   |       | 0.4 |   |
|                                                                             |       |                                     |       |   |   |
| Cash provided by investing activities                                            |       | —                                   |       | 0.4 |   |
|                                                                             |       |                                     |       |   |   |
| Cash flows from financing activities:                                            |       |                                     |       |   |   |
| Borrowings of revolving loan                                                     |       | —                                   |       | 22.1 |   |
| Repayments of revolving loan                                                     |       | —                                   |       | (16.1 | ) |
| Repayments of term loan                                                          |       | —                                   |       | (5.1 | ) |
| Repayments of other project debt                                                 |       | —                                   |       | (1.1 | ) |
| Deferred financing costs                                                         |       | —                                   |       | (0.2 | ) |
|                                                                             |       |                                     |       |   |   |
| Cash used in financing activities                                                |       | —                                   |       | (0.4 | ) |
|                                                                             |       |                                     |       |   |   |
| Net (decrease) increase in cash and cash  equivalents                            |       | (2.6                                     | )          | 7.7 |   |
|                                                                             |       |                                     |       |   |   |
| Cash and cash equivalents - beginning of period                                  |       | 8.9                                      |       | 2.3 |   |
|                                                                             |       |                                     |       |   |   |
| Cash and cash equivalents - end of period                                        |       | $                                        | 6.3        |   | $ | 10.0 |   |
|                                                                             |       |                                     |       |   |   |
| Supplemental disclosures of cash flow information:                               |       |                                     |       |   |   |
| Cash paid during the period for income taxes                                     |       | $                                        | —     |   | $ | 0.1 |   |
| Cash paid during the period for reorganization  items                            |       | 1.9                                      |       | — |   |
|                                                                             |       |                                     |       |   |   |
| Supplemental disclosures of non-cash investing and  financing activities:        |       |                                     |       |   |   |
| Amortization of deferred financing costs  capitalized in real estate inventories |       | $                                        | 1.0        |   | $ | 1.2 |   |
| Decrease in project debt and accrued liabilities  due to debt restructuring      |       | $                                        | —     |   | $ | 28.7 |   |

 

See the accompanying notes to Consolidated Financial Statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

(DEBTOR-IN-POSSESSION)

 

NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS

(UNAUDITED)

 

**Note 1 -Basis of Presentation**

 

Theaccompanying Consolidated Financial Statements have been prepared by CaliforniaCoastal Communities, Inc. and its consolidated subsidiaries (the “Company”),without audit, pursuant to the rules and regulations of the Securities andExchange Commission. Certain information and footnote disclosures normallyincluded in financial statements prepared in accordance with generally acceptedaccounting principles have been condensed or omitted pursuant to suchrules and regulations. The Company believes that these unauditedConsolidated Financial Statements reflect all material adjustments (consistingonly of normal recurring adjustments) and disclosures necessary for the fairpresentation of the results of operations and statements of financial positionwhen read in conjunction with the Consolidated Financial Statements and Notesthereto included in the Company’s Annual Report on Form 10-K for the yearended December 31, 2009 and the current year’s previously issued QuarterlyReport on Form 10-Q. Intercompany accounts and transactions have beeneliminated.

 

The results for interim periods are not necessarily indicative of theresults to be expected for the full year. This report contains forward-lookingstatements. Readers are cautioned that any such forward-looking statements arenot guarantees of future performance and involve risks and uncertainties thatactual events or results may differ materially from those described herein as aresult of various factors, including without limitation, the factors discussedgenerally in this report.

 

*GoingConcern and Financial Reporting in Reorganization*

 

Whilethe Company is striving to replace its senior secured revolving creditagreement (“Revolving Loan”) and senior secured term loan agreement (“Term Loan”)debt with the new financing commitment (see Note 2 below) through the Chapter11 reorganization process (also described below in Note 2), there can be noassurance that the Company will be able to successfully execute such plan.Unless the Company is successful in executing such plan, or otherwise amendingand extending the terms of the Revolving Loan and Term Loan agreements, theCompany does not believe that its cash, cash equivalents and future real estatesales proceeds will provide sufficient liquidity to meet its current debtobligations under the current terms of the existing Revolving Loan agreementand Term Loan agreement as described in Notes 5 and 6, in addition to meetinganticipated operating and project development costs for Brightwater, andgeneral and administrative expenses during the next 12 months. Thesefactors raise substantial doubt about the Company’s ability to continue as agoing concern unless the Company is successful in replacing or restructuringits Revolving Loan and Term Loan debt through confirmation of a plan ofreorganization in the Chapter 11 Cases, including a plan that implements theNew Financing and Additional Capital. The accompanying Consolidated FinancialStatements have been prepared assuming that the Company will continue as agoing concern and contemplate the realization of assets and the satisfaction ofliabilities in the normal course of business. As a result of the Chapter 11reorganization process described below, the realization of assets and the satisfactionof liabilities are subject to uncertainty. While operating as “debtors-in-possession”under Chapter 11, the Company and the other Debtors described below may sell orotherwise dispose of or liquidate assets or settle liabilities, subject to theapproval of the Bankruptcy Court or as otherwise permitted in the ordinarycourse of business, in amounts other than those reflected in the accompanyingConsolidated Financial Statements. Further, a plan of reorganization couldmaterially change the amounts and classifications of assets and liabilities inthe historical consolidated financial statements. The accompanying ConsolidatedFinancial Statements do not include any direct adjustments related to therecoverability and classification of assets or the amounts and classificationof liabilities or any other adjustments that might be necessary should theCompany be unable to continue as a going concern or as a consequence of theChapter 11 Cases.

 

**Note 2 —Chapter 11 Proceedings and Plans of Management**

 

OnOctober 27, 2009, the Company and certain of its direct and indirectwholly-owned subsidiaries (collectively with the Company, the “Debtors”) filedvoluntary petitions (the “Chapter 11 Petitions”) for relief under chapter 11 oftitle 11 (“Chapter 11”) of the United States Code (the “Bankruptcy Code”) inthe United States Bankruptcy Court for the Central District of California (the “BankruptcyCourt”). The Chapter 11 Petitions are being jointly administered under thecaption *In re California Coastal Communities, Inc.*,Case No. 09-21712-TA (the “Chapter 11 Cases”). The Debtors continue to operate 

 

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theirbusinesses and manage their properties as “debtors-in-possession” under thejurisdiction of the Bankruptcy Court and in accordance with the applicableprovisions of the Bankruptcy Code and orders of the Bankruptcy Court. TheDebtors have obtained the Bankruptcy Court’s approval to, among other things,continue to pay critical vendors with lien rights, sell homes free and clear ofall liens on an interim basis, use cash collateral on an interim basis, honorhomeowner warranties, meet payroll obligations and provide employee benefits.There can be no assurance that the Company and the other Debtors will be ableto successfully develop, execute, confirm and consummate one or more plans ofreorganization with respect to the Chapter 11 Cases that are acceptable to theBankruptcy Court and the creditors and other parties in interest, or continueto operate as debtors-in-possession until the Chapter 11 Cases have been fullyadjudicated.

 

TheCompany has 13 direct or indirect consolidated subsidiaries which are notguarantors of the $81.7 million Revolving Loan or the $99.8 million Term Loanand are not Debtors in the Chapter 11 Cases. These subsidiaries are formerowners of businesses unrelated to the Company’s current operations and have nocurrent material operations.

 

*Plansof Management*

 

OnMarch 26, 2010, the Company filed a proposed disclosure statement and proposedjoint plan of reorganization with the Bankruptcy Court and a hearing on theadequacy of the disclosure statement was held on May 12, 2010. Subsequently, onJune 18, 2010, the Company obtained a financing commitment from Luxor CapitalGroup, LP (“Luxor”) to provide $184 million of new debt financing (the “NewFinancing”) that, if funded, will be used to repay the $81.7 millionoutstanding on the Revolving Loan, the $99.8 million outstanding on the TermLoan, and to fund operations. In light of the New Financing, the Company fileda revised disclosure statement and proposed joint plan of reorganization withthe Bankruptcy Court on July 2, 2010.  OnJuly 28, 2010, the Company filed a further amended disclosure statement,disclosing that the Company has agreed that the definitive documentation forthe New Financing will require, as a condition to closing, that the Companyobtains an additional $15 million of financing in the form of (i) indebtednessthat would be subordinated to the New Financing; (ii) equity; or (iii) acombination of debt and equity (the “Additional Capital”).  Prior to theamendment of the disclosure statement and plan, the Court had scheduled a planconfirmation hearing for August 12, 2010, which will be rescheduled.  The outside closing date for the NewFinancing is August 31, 2010. There can be no assurance that the Company willbe able to complete the New Financing or raise the Additional Capital, or thatthe Company and the other Debtors will be able to successfully confirm,consummate and execute their plan of reorganization with respect to the Chapter11 Cases in a manner that is acceptable to the Bankruptcy Court and thecreditors and other parties in interest.

 

TheCompany and the other Debtors continue to operate their business asdebtors-in-possession. The Company has incurred and will continue to incursignificant costs associated with the reorganization which are expected tosignificantly affect the Company’s results of operations. During the six monthsended June 30, 2010, the Company incurred reorganization costs aggregatingapproximately $3.7 million and has incurred total reorganization costs of $5.0million through such date.

 

The Company has maintained business operations through thereorganization process. The Company’s liquidity and capital resources, however,are significantly affected by the Chapter 11 Cases, which have resulted invarious restrictions on its activities, limitations on financing and therequirement of obtaining Bankruptcy Court approval for various matters. Inparticular, the Debtors are not permitted to make any payments on pre-petitionliabilities without prior Bankruptcy Court approval. However, the Debtors havebeen granted relief in order to continue wage and salary payments and otheremployment benefits to employees as well as other related pre-petitionobligations; to continue to construct and sell homes; and to pay certainpre-petition trade claims held by critical vendors with lien rights. TheCompany’s authorization to continue to use cash collateral and to sell homesfree and clear of liens is currently scheduled to terminate on September 8,2010.

 

Under the priority schedule established by the Bankruptcy Code, certainpost-petition and pre-petition liabilities need to be satisfied before generalunsecured creditors and equity holders are entitled to receive anydistribution. At this time, it is not possible to predict with certainty theeffect of the Chapter 11 Cases on the Company’s business or various creditors,or when the Company will emerge from these proceedings. Future results willdepend upon the confirmation and successful implementation of a plan ofreorganization. The continuation of the Chapter 11 Cases, particularly if aplan of reorganization is not timely confirmed, could further adversely affectthe Company’s operations.

 

The Company depends on cash flows generated from operations to fund itsBrightwater development, and to meet its debt service and working capitalrequirements. However, the Company’s ability to continue to generate sufficientcash flows has been and will continue to be adversely affected by continueddifficulties in the homebuilding industry, continued weakness in the Californiaeconomy, and negative publicity and prospective homebuyer concerns related tothe Chapter 11 Cases. While the Company generated 31 net sales orders in thefirst nine months of 2009, it generated only two net sales orders atBrightwater during the fourth quarter of 2009, which the Company believesreflects the negative impact of the Chapter 11 Cases, as well as the seasonalslowdown in sales. Thus far in 2010, the pace of sales has continued to beadversely impacted by the Chapter 11 Cases, with only eight net sales ordersgenerated through August 2, 2010 compared with 20 net sales orders during thecomparable period of 2009.

 

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Continuing negative conditions in the housing and credit markets giverise to uncertainty as to the Company’s present and future ability to meet itsprojected home sale closings and whether the Additional Capital or modified ornew financings can be obtained in order for the Company to meet its debtobligations before and after it emerges from bankruptcy. There can be noassurance that the Company will be successful in any of these endeavors. Whilethe national credit markets appear to be improving, there is limitedavailability of financing for small businesses which presents significantuncertainty as to the ability of the Company to obtain the Additional Capitalwhich is a condition of the New Financing, secure other additional financingand the terms of such Additional Capital or additional financing if it isavailable. The current housing and mortgage markets also present significantuncertainty as to the Company’s ability to achieve sufficient positive cashflow from operations required to satisfy its debt obligations and meetfinancial covenant requirements. See Notes 5 and 6 for further discussion.

 

Basedon Brightwater sales in 2009 and the first half of 2010, the Company does notbelieve that its cash, cash equivalents and future real estate sales proceedswill provide sufficient liquidity to meet its current debt obligations underthe current terms of the existing Revolving Loan Agreement and Term LoanAgreement as described in Notes 5 and 6, in addition to its anticipatedoperating and project development costs for Brightwater, and general andadministrative expenses during the next 12 months. These factors raisesubstantial doubt about the Company’s ability to continue as a going concernunless the Company is successful in replacing or restructuring its RevolvingLoan and Term Loan debt through confirmation of a plan of reorganization in theChapter 11 Cases, including a plan that implements the New Financing andAdditional Capital. The Consolidated Financial Statements herein do not includeany adjustments that might result from the outcome of this uncertainty.

 

*LiabilitiesSubject to Compromise*

 

Liabilitiessubject to compromise refers to pre-petition obligations which may be impactedby the Chapter 11 Cases. These amounts represent the Company’s current estimateof known or potential pre-petition obligations to be resolved in connectionwith the Chapter 11 Cases. Differences between estimated liabilities and theclaims filed or to be filed will be investigated and resolved in connection withthe claims resolution process. The Company continues to evaluate theseliabilities throughout the continuation of the Chapter 11 Cases and adjustsamounts as necessary. Such adjustments may be material. Due to the expectednumber of creditors, the claims resolution process may take considerable timeto complete. Accordingly, the ultimate number and amount of allowed claims isnot presently known.

 

*ReorganizationCosts*

 

Reorganizationcosts include legal and professional fees incurred in connection with theChapter 11 Cases. During the three and six months ended June 30, 2010, theCompany incurred $2.4 million and $3.7 million, respectively, of reorganizationcosts and paid approximately $1.2 million and $1.9 million, respectively, ofsuch costs. The Company has incurred total reorganization costs of $5.0 millionfrom October 2009 through June 30, 2010.

 

*NasdaqDelisting*

 

TheCompany’s common stock was delisted from the Nasdaq Stock Market at the open oftrading on April 27, 2010 as a result of the Company’s inability to emerge fromthe Chapter 11 process by April 26. Since that time, the Company’s common stock has been tradingover-the-counter in the OTCQB marketplace under the trading symbol “CALCQ.” Thetrading of the Company’s common stock in the over-the-counter market ratherthan on Nasdaq may negatively impact the trading price and the levels ofliquidity available to its stockholders. In addition, securities that tradeover-the-counter are not eligible for margin loans and will make the Company’scommon stock subject to the provisions of Rule 15g-9 of the Securities ExchangeAct of 1934, as amended, commonly referred to as the “penny stock rule.”

 

TheCompany has filed an application with Nasdaq seeking the relisting of itssecurities on The Nasdaq Stock Market following the Company’s emergence fromthe Chapter 11 process.  In that regard,all companies, whether listed on Nasdaq or not, are required to satisfy the initiallisting requirements upon emergence from a Chapter 11 process to qualify forlisting.  Given the substantially lowercosts associated with trading on the OTCQB and that the trading, volume andliquidity of the Company’s common stock does not appear to have been impairedsince it commenced trading in the OTCQB marketplace, the Company is consideringwhether to remain on the OTCQB following emergence from the Chapter 11 process.

 

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**Note 3- Significant Accounting Policies**

 

*Basis of Consolidation*

 

The accompanying Consolidated Financial Statements include the accountsof the Company and all majority-owned and controlled subsidiaries and jointventures. Certain of the Company’s wholly-owned subsidiaries are members injoint ventures which were involved in the development and sale of a residentialproject and residential loan production. The Company currently has an interestin one inactive joint venture in which the Company has a controlling ormajority economic interest, and thus is controlled by the Company and isconsolidated with the Company’s financial statements. The Company’s investmentsin unconsolidated joint ventures are accounted for using the equity method whenthe Company does not have voting or economic control of the venture operations,as further described in Note 5 to the Consolidated Financial Statementsincluded in the Company’s Annual Report on Form 10-K for the year ended December 31,2009. All significant intercompany accounts and transactions have beeneliminated in consolidation.

 

*Consequencesof Chapter 11 Cases*

 

Financial Accounting Standards Board (“FASB”) Accounting StandardsCodification (“ASC”) 852-10-45, “*Reorganizations — OtherPresentation Matters*,” which is applicable to companies in Chapter11, generally does not change the manner in which financial statements areprepared. However, it does require that the financial statements for periodssubsequent to the filing of the Chapter 11 Cases distinguish transactions andevents that are directly associated with the reorganization from the ongoingoperations of the business. Amounts that can be directly associated with thereorganization and restructuring of the business must be reported separately asreorganization items in the statements of operations beginning in the quarterending December 31, 2009. The balance sheet must distinguish pre-petitionliabilities subject to compromise from both those pre-petition liabilities thatare not subject to compromise and from post-petition liabilities. Liabilitiesthat may be affected by a plan of reorganization must be reported at theamounts expected to be allowed, even if they may be settled for lesser amounts.In addition, cash provided or used by reorganization items must be disclosedseparately in the statement of cash flows. The Company applied ASC 852-10-45effective on October 27, 2009 and is segregating those items as outlinedabove for all reporting periods subsequent to such date.

 

*Subsequent Events*

 

In the preparation of this Quarterly Report on Form 10-Q, theCompany evaluated events for accounting treatment and disclosure that occurredafter the balance sheet date but before the financial statements were issued orwere available to be issued. See Note 2 for discussion regarding the Chapter 11Cases.

 

*Cash Flows and Debt Compliance*

 

Negative conditions in the current housing and credit markets give riseto uncertainty as to the Company’s present and future ability to meet itsprojected home sale closings and whether the New Financing described above canbe completed. The Company, like many other homebuilders, is constantlyevaluating potential alternatives regarding its capital structure including,but not limited to, various strategies for restructuring its debt and raisingthe Additional Capital and other capital. There can be no assurance that theCompany will be successful in any of these endeavors. The limited credit availabilityfor small businesses presents uncertainty as to the ability of the Company tosecure additional financing and the terms of such financing if it is available,and as to the ability of the Company to achieve positive cash flow fromoperations required to satisfy its obligations. See Notes 5 and 6 belowfor further discussion.

 

*Real Estate*

 

Real estate inventories primarily consist of homes available for sale,homes under construction and lots under development and are carried at thelower of cost or fair value less costs to sell. The estimation process involvedin the determination of fair value is inherently uncertain because it requiresestimates as to future events and market conditions. Such estimation processassumes the Company’s ability to complete development and dispose of its realestate properties in the ordinary course of business based on management’spresent plans and intentions. Economic, market, and environmental conditionswill affect management’s development and marketing plans. In addition, theimplementation of such development and marketing plans could be affected by theavailability of future financing for development and construction activities.Accordingly, the ultimate values of the Company’s real estate properties dependupon future economic and market conditions, and the availability of financing.

 

The cost of sales of multi-unit projects is computed using the relativesales value method. Interest and other carrying costs are capitalized to realestate projects during their development and construction period.

 

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*Impairment of Long-Lived Assets*

 

The Company assesses the impairment of real estate inventories andother long-lived assets in accordance with ASC 360-10-35, “*Impairment or Disposal of Long-Lived Assets,”*which requires that long-lived assets be reviewed for impairment wheneverevents or changes in circumstances indicate that the carrying amount of anasset may not be recoverable. Impairment is evaluated by comparing an asset’scarrying value to the undiscounted estimated cash flows expected from the asset’soperations and eventual disposition. If the sum of the undiscounted estimatedfuture cash flows is less than the carrying value of the asset, an impairmentloss is recognized based on the fair value of the asset. If impairment occurs,the fair value of an asset is deemed to be the amount a willing buyer would paya willing seller for such asset in a current transaction. Additionally, asappropriate, the Company identifies alternative courses of action to recoverthe carrying value of its long-lived assets and evaluates all likelyalternatives under a probability-weighted approach as described in ASC360-10-35.

 

During the three months ended June 30, 2010, the Company recordedan impairment charge of $6.0 million with respect to its Brightwater project.See Note 4 — Real Estate Inventories. During the comparable periods in 2009,the Company recorded zero Brightwater project impairment charges and inlandproject impairment charges totaling zero and $3.2 million, respectively.

 

In making its determination to record a Brightwater project impairment,the Company has incorporated various market assumptions including thoseregarding home prices, sales pace, sales and marketing costs, infrastructureand home-building costs, and financing costs regarding real estate inventoriesin accordance with ASC 360-10-35, in developing estimated future cash flows forimpairment testing for its real estate inventories. The Company’s assumptionsare based, in part, on general economic conditions, the current state of thehomebuilding industry, expectations about the short- and long-term outlook forthe housing market, and competition from other homebuilders in the areas inwhich the Company builds and sells homes. These assumptions can significantlyaffect the Company’s estimates of future cash flows. For those communitiesdeemed to be impaired, the Company determines fair value based on discountedestimated future cash flows using estimated absorption rates for eachcommunity.

 

The estimation process involved in the determination of value isinherently uncertain since it requires estimates as to future events and marketconditions. Such estimation process assumes the Company’s ability to completedevelopment and disposition of its real estate properties in the ordinarycourse of business based on management’s present plans and intentions. Economicand market conditions may affect management’s development and marketing plans.In addition, the implementation of such development and marketing plans couldbe affected by the availability of future financing for development andconstruction activities. Accordingly, the amount ultimately realized from suchproject may differ materially from current estimates and the project’s carryingvalue.

 

*Fair Value of Financial Instruments*

 

The Company adopted ASC 820-10 *“FairValue Measurements and Disclosures,”* as it applies to financialassets and liabilities measured at fair value on a recurring basis onJanuary 1, 2008 and as it applies to non-financial assets and liabilitieson January 1, 2009. The carrying amounts of the Company’s financialinstruments including cash and cash equivalents, restricted cash, accountspayable and accrued liabilities, model home financing, and other liabilitiesapproximate their respective fair values because of the relatively short periodof time between origination of the instruments and their expected realization.Due to the Chapter 11 Cases and current default status of the Company’sRevolving Loan and Term Loan, the carrying amounts of the debt may notapproximate fair value as of June 30, 2010. Accordingly, the fair value ofdebt that is included in liabilities subject to compromise in the Company’sconsolidated balance sheets cannot be reasonably determined as of June 30,2010, as the timing and amounts to be paid are subject to confirmation by theBankruptcy Court. The Company has been notified that purchase/sale transactionsinvolving the Revolving Loan and Term Loan have occurred between certainmembers of the loan syndicates and other financial or investment institutions.However, it is not practicable for the Company to determine the fair value ofthe Revolving Loan and Term Loan as the transactions are occurring in a privatemarket.

 

The following table summarizes the Company’s fair value measurements atJune 30, 2010 (in millions):

 
| **Description**         | ** ** | **Fair Value  Hierarchy** | ** ** | **Fair Value** | ** ** | **Impairment Charges for  the Six Months Ended  June 30, 2010** | ** ** |
|-------------------------|------------|---------------------------|------------|----------------|------------|----------------------------------------------------------------------|------------|
| Real estate inventories |       | Level 3                   |       | $              | 227.0      |                                                                 | $          | 6.0 |   |
|                         |            |                           |            |                |            |                                                                      |            |  |  |

 

In accordance with ASC 360, real estate inventories with a carryingvalue of $233.0 million were determined to be impaired during the three monthsended June 30, 2010, and were written down to their estimated fair valueof $227.0 million, resulting in an impairment charge of $6.0 million. See “*Impairment of Real Estate Inventories*” above and Note 4 —Real Estate Inventories.

 

*Income Taxes*

 

The Company accounts for income taxes on the liability method, inaccordance with ASC 740-10, “*Income Taxes.*”Deferred income taxes are determined based on the difference between thefinancial statement and tax bases of assets and liabilities, using enacted taxrates in effect in the years in which these differences are expected toreverse. The liability method requires an evaluation of the probability ofbeing able to realize the future benefits indicated by deferred tax assets. A 

 

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valuationallowance is established against a deferred tax asset if, based on theavailable evidence, it is “more likely than not” that such asset will not berealized. The realization of a deferred tax asset ultimately depends on theexistence of sufficient taxable income in either the carryback or carryforwardperiods under tax law. The Company evaluates on a quarterly basis, whether a valuationallowance should be established based on its determination of whether it is “morelikely than not” that some portion or all of the deferred tax assets will berealized. In the Company’s assessment, appropriate consideration is given toall positive and negative evidence related to the realization of the deferredtax assets. This assessment considers, among other matters, the nature,frequency and magnitude of current and cumulative income and losses, forecastsof future profitability, the duration of statutory carryback or carryforwardperiods, the Company’s experience with operating loss and tax creditcarryforwards not expiring unused, and tax planning alternatives.

 

The Company’s assessment of the need for a valuation allowance on itsdeferred tax assets includes assessing the likely future tax consequences ofevents that have been recognized in the Company’s Consolidated FinancialStatements or tax returns. The Company bases its estimate of deferred taxassets and liabilities on current tax laws and rates and, in certain cases, onbusiness plans and other expectations about future outcomes. Changes inexisting tax laws or rates could affect the Company’s actual tax results andits future business results may affect the amount of the Company’s deferred taxliabilities or the valuation of its deferred tax assets over time.

 

During the three and six months ended June 30, 2010, the Companyrecorded valuation allowance adjustments on deferred tax assets totaling $2.4million and $3.4 million, respectively. During the comparable periods in 2009,the Company recorded valuation allowance adjustments on deferred tax assetstotaling $7.6 million and $7.6 million, respectively. See Note 9—IncomeTaxes.

 

Due to uncertainties in the estimation process, particularly withrespect to changes in facts and circumstances in future reporting periods(carryforward period assumptions), it is reasonably possible that actualresults could differ from the estimates used in the Company’s historicalanalyses. The Company’s assumptions require significant judgment because theresidential homebuilding industry is cyclical and is highly sensitive tochanges in economic conditions. The Company’s current assessment of the needfor a valuation allowance is primarily dependent upon utilization of tax netoperating losses in the carryforward period and its future projected taxableincome. The Chapter 11 filing constitutes significant negative evidence underASC 740-10 as it represents uncertainties related to future projected taxableincome. Additionally, there are critical uncertainties as to whether theCompany will be able to continue selling homes at its Brightwater project usingcurrently projected sales prices and absorption rates in light of thecontinuing deterioration in the housing and credit markets. If the Companyutilizes a portion of its NOLs or certainty increases regarding the Company’suse of its NOLs due to projected results of operations and there is objectivelyverifiable evidence to support the expected realization of a portion of itsdeferred tax assets, an adjustment to the Company’s valuation allowance may berecorded to reflect greater expected utilization. In addition, in the event ofan ownership change which could result from the Company’s emergence from Chapter11 under the proposed plan of reorganization, the utilization of tax netoperating losses in the carryforward period is likely to be materiallyjeopardized.

 

*Homebuilding Revenues and Cost of Sales*

 

The Company’s homebuilding operation generates revenues from the saleof homes to homebuyers. The majority of these homes are designed to appeal tomove-up homebuyers and are generally offered for sale in advance of theirconstruction. Sales contracts are usually subject to certain contingencies suchas the buyer’s ability to qualify for financing. Revenue from the sale of homesis recognized at the close of escrow when title passes to the buyer and theearnings process is complete. As a result, the Company’s revenue recognitionprocess does not involve significant judgments or estimates. However, theCompany does rely on certain estimates to determine the related constructioncosts and resulting gross margins associated with revenues recognized. The costof sales is recorded based upon total estimated costs within a subdivision andallocated using the relative sales value method. The Company’s constructioncosts are comprised of direct and allocated costs, including estimated costsfor future warranties and indemnities. The Company’s estimates are based onhistorical results, adjusted for current factors.

 

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*Earnings Per Common Share*

 

Earnings per common share is accounted for in accordance with ASC260-10, “*Earnings Per Share*.”Basic earnings per common share is computed using the weighted-average numberof common shares outstanding for the period. Diluted earnings per common shareis computed using the weighted-average number of common shares outstanding andthe dilutive effect of potential common shares outstanding.

 

*New Accounting Pronouncements*

 

In January 2010, the FASB issued Accounting Standards Update (“ASU”)No. 2010-06 (“ASU 2010-06”), “*Fair Value Measurementsand Disclosures (Topic 820) — Improving Disclosures about Fair ValueMeasurements*,” which requires new disclosures and clarifications ofexisting disclosures for recurring and nonrecurring fair value measurements.ASU 2010-06 is effective for interim and annual periods beginning after December 15,2009. The adoption of ASU 2010-06 during the first quarter of 2010 did not havea material effect on our Consolidated Financial Statements.

 

**Note 4 —Real Estate Inventories**

 

Real estate inventories primarily consist of homes under constructionand lots under development at Brightwater, along with a five-acre project beingplanned for 22 homes, in Huntington Beach in coastal Orange County and oneinland community in Lancaster in Los Angeles County planned for 73 homes. As ofJune 30, 2010, real estate inventories aggregated 283 lots and homes,including 17 model homes, nine standing inventory homes completed and unsold,one home completed and in escrow, and five homes under construction and inescrow. Real estate inventories at June 30, 2010 included $232.1 millionrecorded for 266 lots and homes under development and 17 model homes held undera financing lease at the Brightwater community as well as a five-acre projectoutside the Brightwater community, which are located on a mesa north of theBolsa Chica wetlands in Huntington Beach, California. The additional recordedvalue in real estate inventories reflects 73 lots at the Company’s subsidiary’sinland project in Lancaster, California. The Company capitalizes carrying costsincluding interest and property taxes, as well as direct construction costs, toreal estate inventories during the development and construction period.

 

The Brightwater planned community offers a broad mix of home choices,averaging 2,860 square feet and ranging in size from 1,710 square feet to 4,339square feet. The community also has 37 acres of open space and conservationarea. With 356 homes permitted on 68 acres, the resulting low-density planequates to approximately five homes per acre, consistent and compatible withthe neighboring Huntington Beach communities. The Company began selling anddelivering homes at The Trails and The Sands in 2007. Sales of the larger twoproducts, The Cliffs and The Breakers, began in February 2008 and the Companybegan delivering homes at The Cliffs and The Breakers neighborhoods during thethird quarter of 2008.

 

During the second quarter of 2010, a non-Debtor subsidiary of theCompany sold a 60-acre parcel of land in Huntington Beach, California which wasencumbered by an oil lease and a conservation easement for $1.4 million.

 

During the three months ended June 30, 2010, the Company recordedan impairment charge of $6.0 million with respect to its Brightwater project.During the three and six months ended June 30, 2009, the Company recordedinland project impairment charges totaling zero and $3.2 million, respectively.

 

As required by ASC 360-10-35, should market conditions deteriorate inthe future or other events occur that indicate the carrying amount of the Company’sreal estate inventories may not be recoverable, the Company will reevaluate theexpected cash flows from each project to determine whether any additionalimpairment exists at any point in time.

 

Capitalizedinterest is allocated to real estate inventories when incurred and charged tocost of sales when the related property is delivered. Changes in capitalizedinterest follow (in millions):

 
| ** **                                | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                | ** ** | **2010**                                        | ** ** | **2009**                                      | ** ** | **2010** | ** ** | **2009** | ** ** |
| Capitalized interest, beginning of period |       | $                                               | 39.2       |                                          | $          | 35.7 |   | $ | 36.8 |   | $ | 37.3 |   |
| Interest incurred and capitalized         |       | 3.1                                             |       | 3.2                                           |       | 6.1 |   | 7.2 |   |
| Charged to cost of sales                  |       | (1.6                                            | )          | (1.4                                          | )          | (2.2 | ) | (2.8 | ) |
| Charged to gain on debt restructuring     |       | —                                          |       | —                                        |       | — |   | (4.2 | ) |
| Capitalized interest, end of period       |       | $                                               | 40.7       |                                          | $          | 37.5 |   | $ | 40.7 |   | $ | 37.5 |   |

 

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**Note 5 —Revolving Loan**

 

See Note 2 for a detailed discussion of the status of the Chapter 11Cases which commenced October 27, 2009. Since that date, the Company has not made any payments of principal onthe Revolving Loan or the Term Loan described below in Note 6; however theCompany continues to pay interest on the outstanding principal balances atagreed upon non-default interest rates.

 

As of June 30, 2010 and December 31, 2009, $81.7 million wasoutstanding for both periods under the Revolving Loan. The Company did not pay$1.7 million of principal due on September 30, 2009, and received a noticeof event of default from the agent for the lending syndicate on October 1,2009. In addition, the Company did not pay an additional $10.0 million due on December 31,2009 and $10.0 million due on March 31, 2010, and did not repay the loanin full on the June 30, 2010 maturity date resulting in an aggregate of$81.7 million of principal due and unpaid as of June 30, 2010.

 

Interest on the facility is calculated on the average outstanding dailybalance and is paid monthly. Interest incurred on the Revolving Loan for thethree and six months ended June 30, 2010 was $1.0 million and $1.9million, respectively, at a weighted-average interest rate of 3.54% and 3.52%,respectively. Interest incurred on the Revolving Loan for the three and six monthsended June 30, 2009 was $1.0 million and $2.2 million, respectively, atweighted-average interest rates of 3.67% and 3.74%, respectively.  Following the Company’s $1.7 millionprincipal payment default, effective October 1, 2009, interest began to accrueat the default rate specified in the loan; however, under the terms of theBankruptcy Court’s cash collateral order, the Company continued paying interestat the non-default rate of LIBOR + 3.25% and was current on such interestpayments as of June 30, 2010. On July 28, 2010, the Bankruptcy Courtapproved a settlement agreement between the Debtors, the agent and the existinglenders that provided, among other things, that no default interest will be dueand reduced the amount of legal and professional fees payable by the Debtors tothe agent.

 

As of June 30, 2010, the Company has delivered 90 homes atBrightwater since inception of the project, including the 17 model homesincluded in the sale-leaseback transaction completed on December 31, 2008and ten homes (five Trails, one Sands, three Cliffs and one Breakers) deliveredduring the six months ended June 30, 2010. Due to the Chapter 11 Cases, noprincipal payments were made on the 20 homes delivered during the fourthquarter of 2009 and the first half of 2010.

 

As of June 30, 2010 and December 31, 2009, approximately zeroand $500,000, respectively, of deferred loan fees and closing costs related tothe Revolving Loan are included in other assets and were amortized over theexpected life of the loan. Amortization of these costs is included in thecapitalization of interest allocated to real estate inventories and charged tocost of sales when the related homes are delivered.

 

Under the Revolving Loan, the Company is required to comply with anumber of covenants, including the following financial covenants which theCompany considers to be the most restrictive of all of the debt covenants:

 

·                  A leverage covenant thatprohibits the Company’s ratio of consolidated total liabilities to consolidatedtangible net worth from exceeding a maximum ratio of 2.5 to 1.0. Thecalculation of the covenant excludes impairment charges related to inlandprojects and valuation allowances on deferred tax assets.

 

·                  A loan-to-value ratio, whichprohibits the Company’s ratio of Revolving Loan debt outstanding to borrowingbase value from exceeding 30%, regarding which the Company has been notified itis in default.

 

·                  A minimum consolidatedtangible net worth covenant of $80 million, excluding impairment charges forthe Hearthside Lane and Las Colinas projects and valuation allowances ondeferred tax assets.

 

·                  A prohibition on dividends.

 

As of June 30, 2010, the Company’s consolidated total liabilitiesare $219.7 million, tangible net worth after excluding the 2009 and 2008 inlandimpairment charges and valuation allowances on deferred tax assets is $97.6 millionand the leverage ratio is 2.25. The Company is in compliance with the leverageand net worth covenants. However, the Company was notified on September 28,2009 that it is not in compliance with the loan-to-value ratio covenant of theRevolving Loan based on an appraisal obtained in August 2009 by the agent forthe Revolving Loan and Term Loan.  Inaddition, the Company is not in compliance with the minimum sales covenantwhich requires that the sum of the cumulative number of homes delivered as of June 30,2010 plus 50% of the number of homes in escrow at June 30, 2010 equal orexceed 96. As of June 30, 2010, the Company had delivered 90 homes and hadsix homes in escrow for minimum sales of 93. Under the proposed Chapter 11 planof reorganization, these covenants would be eliminated.

 

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While the sales pace at Brightwater was close to expectations at thebeginning of 2009, the mix of sales was heavily weighted towards smaller homeswhich are generating less liquidity than the larger homes.  The Company did not meet its mandatoryprincipal repayments due on September 30, 2009, December 31, 2009, orMarch 31, 2010 and was unable to fully repay the Revolving Loan by its currentmaturity date on June 30, 2010 from cash flow from operations.  Through the Chapter 11 reorganizationprocess, the Company is striving to replace the Revolving Loan and Term Loanwith the New Financing which would have scheduled amortization payments thatwill accommodate the expected sales pace of the Brightwater project and,together with the Additional Capital, would provide sufficient liquidity tofund continued home construction.  Therecan be no assurance that the Company will be successful in any of theseendeavors. While the national credit markets appear to be improving, there islimited availability of financing for small businesses, which presentssignificant uncertainty as to the ability of the Company to secure additionalfinancing, and the terms of such financing if available. The current housingand jumbo mortgage markets also present uncertainty as to the ability of theCompany to achieve sufficient positive cash flow from operations required tosatisfy its current debt obligations.

 

**Note 6 —TermLoan**

 

See Note 2 for detaileddiscussion of the status of the Chapter 11 Cases which commenced October 27,2009. Since that date, the Company has not made any payments ofprincipal on the Term Loan or the Revolving Loan described above in Note 5;however the Company continues to pay interest on the outstanding principalbalances at agreed upon non-default interest rates.

 

As of June 30, 2010 and December 31, 2009, $99.8 millionwas outstanding for both periods under the Term Loan.  The Company did not pay $9.8 million, $15.0million, and $10.0 million due on December 31, 2009, March 31, 2010,and June 30, 2010, respectively, resulting in an aggregate of $34.8million of principal due and unpaid as of June 30, 2010.

 

Interest on the facility is calculated on the average outstanding dailybalance and is paid monthly. Interest incurred on the Term Loan for the threeand six months ended June 30, 2010 was $1.3 million and $2.6 million,respectively, at weighted-average interest rates of 4.29% and 4.27%,respectively. Interest incurred on the Term Loan for the three and six monthsended June 30, 2009 was $1.5 million and $3.2 million, respectively, atweighted-average interest rates of 4.41% and 4.74%, respectively.  Following the Company’s $1.7 million principalpayment default on the Revolving Loan, effective October 1, 2009, interestunder the Term Loan began to accrue at the default rate specified in the loan;however, under the terms of the Bankruptcy Court’s cash collateral order, theCompany continued paying interest at the non-default rate of LIBOR +4.00% andwas current on such interest payments as of June 30, 2010. On July 28,2010, the Bankruptcy Court approved a settlement agreement between the Debtors,the agent and the existing lenders that provided, among other things, that nodefault interest will be due and reduced the amount of legal and professionalfees payable by the Debtors to the agent.

 

The Term Loan is subject to mandatory repayments and commitmentreductions based on 60% of the $600,000 release price on the first 70 unitsclosed at the Brightwater project, and 60% of the $1.0 million releaseprice per unit thereafter. As of September 30, 2009, the Company haddelivered 70 homes. These mandatory repayments are applicable to the commitmentreductions.  However, due to the Chapter11 Cases, no principal payments were made on the additional 20 homes deliveredduring the fourth quarter of 2009 and first half of 2010.

 

As of June 30, 2010, the Company has delivered 90 homes atBrightwater since inception of the project, including the 17 model homesincluded in the sale-leaseback transaction completed on December 31, 2008and 10 homes (five Trails, one Sands, three Cliffs and one Breakers) deliveredduring the six months ended June 30, 2010, and made cumulative mandatoryrepayments for the Term Loan of $25.2 million.

 

As of June 30, 2010 and December 31, 2009, approximately $1.3million and $1.9 million, respectively, of deferred loan fees and closingcosts related to the Term Loan are included in other assets and amortized overthe life of the loan. Amortization of these costs is included in thecapitalization of interest allocated to real estate inventories, and charged tocost of sales when the related homes are delivered.

 

Under the Term Loan, the Company is required to comply with a number ofcovenants, including the following financial covenants which the Companyconsiders to be the most restrictive of all of the debt covenants:

 

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·                  A leverage covenant thatprohibits the Company’s ratio of consolidated total liabilities to consolidatedtangible net worth from exceeding a maximum ratio of 2.50 to 1.0. Thecalculation of the covenant excludes impairment charges related to inlandprojects and valuation allowances on deferred tax assets.

 

·                  A loan-to-value ratio, whichprohibits the Company’s ratio of Term Loan debt outstanding to borrowing basevalue from exceeding a maximum ratio, regarding which the Company has beennotified it is in default:

 
| **Reporting Period**                                 | ** ** | **Maximum  Loan-to-Value  Ratio** | ** ** |
|------------------------------------------------------|------------|-----------------------------------|------------|
| March 31, 2010 through September 29,  2010 |       | 60                                | %          |
| September 30, 2010 and thereafter               |       | 45                                | %          |

 

·                  An interest coveragecovenant which prohibits the Company’s ratio of EBITDA to interest incurredfrom being less than 2.00 to 1.00.

 

·                  A minimum consolidatedtangible not worth covenant of $80 million, excluding impairment charges forinland projects and valuation allowances on deferred tax assets.

 

·                  A prohibition on dividends.

 

As of June 30, 2010, the Company’s consolidated total liabilitiesare $219.7 million, tangible net worth after excluding the 2009 and 2008inland impairment charges and valuation allowances on deferred tax assets is $97.6million and the leverage ratio is 2.25. The Company is in compliance with theaforementioned covenants except for the loan-to-value and interest coveragecovenants. The Company was notified on September 28, 2009 that it is notin compliance with the loan-to-value ratio covenant of the Term Loan based onan August 2009 appraisal obtained by the agent for the Revolving Loan andTerm Loan.  In addition, the Company isnot in compliance with the minimum sales covenant which requires that the sumof the cumulative number of homes delivered as of June 30, 2010 plus 50%of the number of homes in escrow at June 30, 2010 equal or exceed 96. Asof June 30, 2010, the Company had delivered 90 homes and had six homes inescrow for minimum sales of 93. Under the proposed Chapter 11 plan ofreorganization, these covenants would be eliminated.

 

While the sales pace at Brightwater was close to expectations at thebeginning of 2009, the mix of sales was heavily weighted towards smaller homeswhich are generating less liquidity than the larger homes. Therefore, theCompany did not make the mandatory repayments due on December 31, 2009, March 31,2010 or June 30, 2010. Through the Chapter 11 reorganization process, theCompany is striving to replace the Revolving Loan and Term Loan with the NewFinancing which would extend the maturity dates of the loans and deferscheduled amortization payments in order to accommodate the expected sales paceof the Brightwater project and, together with the Additional Capital, wouldprovide sufficient liquidity to fund continued home construction. There can beno assurance that the Company will be successful in any of these endeavors.While the national credit markets appear to be improving, there is limitedavailability of financing for small business, which presents uncertainty as tothe ability of the Company to secure additional financing, and the terms ofsuch financing, if available. The current housing and mortgage markets alsopresent uncertainty as to the ability of the Company to achieve sufficientpositive cash flow from operations required to satisfy its current debtobligations.

 

**Note 7—ModelHome Financing**

 

On December 31, 2008, the Company entered into a sale-leasebacktransaction for 17 model homes at its Brightwater project with an unrelatedthird party investor for $25.0 million, consisting of $22.5 millioncash, $2.0 million deferred and payable in two years provided there hasnot been a significant decrease in the value of the model homes, and $500,000payable for conversion of the model homes for sale to homebuyers upontermination of the lease agreement. The Company has an option to repurchase themodel homes after at least 90% of the homes of the respective model type havesold, but no earlier than January 1, 2011. If the Company does notrepurchase the models, after the lessor receives a 16% internal rate of return,the Company is entitled to receive 75% of any profit resulting from the sale ofthe models at the end of the lease. Due to the Company’s repurchase option andprofit participation which constitute continuing interest, and in accordancewith ASC 840-40, “*Sale-Leaseback Transactions*,” theCompany accounted for the transaction as a financing transaction rather than asa sale and recorded model home financing debt of $22.5 million.

 

The Company utilized $10.2 million of the model home financingproceeds to make mandatory repayments under the Revolving Loan and Term Loan,thereby reducing the payments that would have been due in 2009. The Companyused an additional $10.7 million of the proceeds to reduce the balanceoutstanding under the revolving credit agreement. See Notes 5 and 6 foradditional discussion.

 

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In connection with the sale-leaseback transaction, the Company agreedto assign the first $500,000 of proceeds from sales commissions resulting fromthe eventual resale of the model homes, or additional purchase price received,to its partner in the Oxnard joint venture, which is an affiliate of theinvestor who purchased the model homes. The $500,000 payment representsadditional capital contributions that become payable upon the dissolution ofthe joint venture.

 

The model home lease allowed the Company to utilize the 17 model homesfor continued customer display for a term of three years expiringDecember 31, 2011, with two renewal options for one year each. During thethree and six months ended June 30, 2010, the Company made model homelease payments totaling $788,000 and $1.6 million, respectively. Monthly leasepayments of $262,500 per month are due through December 2010, and $279,167per month in 2011.

 

The future minimum lease payments under the terms of the related leaseagreement are as follows (in millions):

 
| **Year** | ** ** | **Amount** | ** ** |
|----------|------------|------------|------------|
| 2010     |       | $          | 1.6        |   |
| 2011     |       | 3.3        |       |
| Total    |       | $          | 4.9        |   |

 

**Note 8- Other Liabilities (Not Subject to Compromise and Subject to Compromise)**

 

Asof June 30, 2010 and December 31, 2009, other liabilities not subjectto compromise included contingent indemnity and environmental obligationstotaling $400,000.

 

Asof June 30, 2010 and December 31, 2009, other liabilities subject tocompromise were comprised of the following (in millions):

 
| ** **                                         | ** ** | **Subject to Compromise** | ** ** |
|----------------------------------------------------|------------|---------------------------|------------|
| ** **                                         | ** ** | **June 30,  2010**   | ** ** | **December 31,  2009** | ** ** |
| Accrued pensions and benefits                      |       | $                         | 5.5        |   | $ | 5.5 |   |
| Home warranty reserves                             |       | 1.9                       |       | 1.9 |   |
| Contingent indemnity and environmental obligations |       | 0.7                       |       | 0.7 |   |
| Capital contribution due to joint venture          |       | 0.5                       |       | 0.5 |   |
| Unamortized discount                               |       | (0.3                      | )          | (0.3 | ) |
|                                               |       | $                         | 8.3        |   | $ | 8.3 |   |

 

Contingent indemnity and environmental obligations primarily reflectreserves before related discount (recorded pursuant to Fresh-Start Reporting in1997) for contingent indemnity obligations for businesses disposed of by formeraffiliates and unrelated to the Company’s current operations.

 

*HomeWarranty Reserve*

 

TheCompany provides a home warranty reserve to reflect its contingent obligationfor product liability. The Company generally records a provision as homes aredelivered, based upon historical and industry experience, for the items listedin the homeowner warranty manual, which does not include items that are coveredby manufacturers’ warranties or items that are not installed by the Company’semployees or contractors. The home warranty reserve activity is presented below(in millions):

 
| ** **                           | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                           | ** ** | **2010**                                        | ** ** | **2009**                                      | ** ** | **2010** | ** ** | **2009** | ** ** |
| Balance at beginning of period       |       | $                                               | 1.9        |                                          | $          | 1.7 |   | $ | 1.9 |   | $ | 1.7 |   |
| Provision                            |       | —                                          |       | 0.1                                           |       | — |   | 0.1 |   |
| Adjustment due to change in estimate |       | —                                          |       | —                                        |       | — |   | — |   |
| Payments                             |       | —                                          |       | —                                        |       | — |   | — |   |
| Balance at end of period             |       | $                                               | 1.9        |                                          | $          | 1.8 |   | $ | 1.9 |   | $ | 1.8 |   |

 

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**Note 9- Income Taxes**

 

Thefollowing is a summary of the tax expense (benefit):

 
| ** **                                  | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                  | ** ** | **2010**                                        | ** ** | **2009**                                      | ** ** | **2010** | ** ** | **2009** | ** ** |
| Current taxes                               |       | $                                               | —     |                                          | $          | — |   | $ | — |   | $ | — |   |
| Deferred taxes                              |       | (2.4                                            | )          | 0.2                                           |       | (3.4 | ) | 7.9 |   |
| Valuation allowances on deferred tax assets |       | 2.4                                             |       | 7.6                                           |       | 3.4 |   | 7.6 |   |
| Income tax expense (benefit)                |       | $                                               | —     |                                          | $          | 7.8 |   | $ | — |   | $ | 15.5 |   |

 

During 2009 and the first half of 2010, the Companyrecorded valuation allowances for the entire amount of its net deferred taxassets due to uncertainties regarding the resolution of the Chapter 11 Casesfiled October 27, 2009. The Chapter 11 filing constitutes significantnegative evidence under ASC 740-10 as it represents uncertainties related tofuture projected taxable income. At this time, the Company is unable toconclude that it is “more likely than not” that the Company would be able togenerate sufficient projected taxable income in future years in order toutilize its NOLs except to offset existing net deferred tax liabilities. TheCompany monitors the availability of real estate for development ateconomically viable prices, market conditions and other objectively verifiableeconomic factors affecting the Company’s operations, as well as other positiveand negative factors, as it assesses valuation allowances against its deferredtax assets.

 

During the fourth quarter of 2009, the Company recorded a $950,000 taxreceivable related to the November 6, 2009 passage of the Worker,Homeownership and Business Assistance Act of 2009 which allows businesses withNOLs for 2008 and 2009 to carry back losses for up to five years and suspendsthe 90% limitation on the use of any alternative tax NOL deduction attributableto carry backs of the applicable NOL. In June 2010 the Company filed arefund claim for federal alternative minimum tax paid for years prior to 2009and anticipates receiving the refund during 2010.

 

The federal NOLs available as of June 30, 2010 were approximately$163 million. The amount of federal NOLs which expire if not utilized is$48 million in 2010, $42 million in 2011, zero in 2012, 2013 and2014, and $73 million thereafter.

 

The Internal Revenue Code (the “Code”) generally limits theavailability of NOLs if an ownership change occurs within any three-year periodunder Section 382. If the Company were to experience an ownership changeof more than 50%, the use of all remaining NOLs would generally be subject toan annual limitation equal to (i) the value of the Company’s equity before theownership change, multiplied by the long-term tax-exempt rate (4.01% as of August 2010)plus (ii) recognized built-in-gains, defined as those gains recognizedwithin five years of the ownership change subject to an overall limitation ofthe net unrealized built-in gains subject to a $10 million minimum existing asof the ownership change date, if applicable. The Company estimates that aftergiving effect to various transactions by stockholders who hold a 5% or greaterinterest in the Company, it has experienced a three-year cumulative ownershipshift of approximately 44% as of August 2, 2010, as computed in accordancewith Section 382. The cumulative shift includes the effect of anapproximate 15% ownership shift which occurred in the second quarter of 2010upon the sale of a large stockholder’s position.  The Company’s net deferred tax assets arecurrently fully reserved due to the uncertainty of the timing and amount offuture taxable income.  If certaintyincreases regarding the Company’s use of its NOLs or projected results ofoperations and there is objectively verifiable evidence to support the expectedrealization of a portion of its deferred tax assets, an adjustment to theCompany’s valuation allowance may be recorded to reflect greater expectedutilization.  In the event of anownership change, which could result from the Company’s emergence from Chapter11 under the proposed plan of reorganization, the utilization of tax netoperating losses in the carryforward period would be materially jeopardized.

 

InSeptember 2006, the Company’s Board of Directors suspended enforcement ofthe Company’s charter documents that restrict stockholders from acquiring morethan 5% of the outstanding shares of common stock. At that time, the Boarddetermined that such restrictions were not required to preserve the taxbenefits of the Company’s NOLs. However, transactions by holders of over 5% ofthe Company’s common stock during the past three years necessitated thereinstatement of this control in order to ensure that the 50% change inownership threshold is not exceeded which, under IRS rules, would severelylimit the Company’s use of its NOLs. Therefore, on May 13, 2010, the Company reinstated a ban onacquisitions of additional shares of its common stock, under certaincircumstances, in order to preserve the tax benefits of the Company’s $163million of NOLs.  In accordance withprovisions of the Company’s charter documents, unless the Company haspreviously consented in writing (i) no stockholder may acquire shares inan amount that would cause the stockholder to own 5% or more of the commonstock; and (ii) no current 5% or greater stockholder may acquire anyadditional shares of common stock.

 

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All acquisitions of the Company’s common stock in violation of itscharter prohibitions are null and void, and the Company is empowered toeffectively reverse the effect of any such acquisitions.  The Company’s Board of Directors may, but isnot required to, entertain requests for permission to exceed the limitations onstock acquisitions under circumstances it determines are not likely tojeopardize the Company’s ability to preserve and use its NOLs.

 

*Uncertain Tax Positions*

 

The Company adopted the provisions of ASC 740-10 as it applies touncertain tax positions on January 1, 2007. As a result of theimplementation, during the first quarter of 2007, the Company recorded a$5.1 million decrease in deferred tax assets for unrecognized taxbenefits, which was offset by an increase in deferred tax assets of$1.8 million for assets re-evaluated as recognizable. The net change indeferred tax assets of $3.3 million was recorded as a cumulative effect ofa change in accounting principle and resulted in a decrease to theJanuary 1, 2007 retained earnings balance of $200,000 and a decrease tothe additional paid in capital balance of $3.1 million related tofresh-start accounting pursuant to a 1997 pre-packaged bankruptcy.

 

Of the Company’s unrecognized tax benefits of $4.9 million at June 30,2010, $100,000 would decrease the Company’s effective tax rate if recognized.The Company expects that its unrecognized tax benefits will decrease byapproximately $1.5 million within 12 months of the reporting date due tostatutes of limitation lapses.

 

The Company recognizes interest expense and penalties related touncertain tax positions as interest or other expense. As of June 30, 2010,the Company has not recorded any interest or penalties related to unrecognizedtax benefits, due to the substantial NOLs available.

 

Certain tax year filings remain open to Federal and Californiaexamination, which are the Company’s only tax jurisdictions. The years 2006through 2009 remain open for Federal purposes for which the Company utilizedNOLs generated between 1990 and 1993 to offset taxable income. The years 2005through 2009 remain open for California purposes during which time the Companyutilized NOLs generated in 2008.  Ifuncertainties resulting in valuation allowances can be favorably resolved, theCompany expects to utilize a portion of Federal NOLs generated in 1995 through1997 and in 1999, 2006, 2007 and 2009 in future years. In addition, the Companywould expect to utilize California NOL generated in 2007 and 2009 in futureyears.

 

Pursuant to ASC 718-740, “*Stock Compensation —Income Taxes*,” the Company has elected to recognize stock optiondeductions on the tax law ordering method, which maximizes the realization ofthe stock option deductions in the current year. While the Company realized themajority of its 2006 stock option deductions, approximately $400,000 ofunrealized tax benefits related to stock option deductions are not reflected inthe Consolidated Financial Statements. Upon realization of the tax benefits,the Company would increase its additional paid-in capital.

 

**Note 10- Commitments and Contingencies**

 

*Real Estate Matters*

 

The Company has outstanding performance and surety bonds, for thebenefit of city and county jurisdictions, related principally to itsobligations for site improvements and fees primarily for the Brightwaterproject. At this time, the Company does not believe that a material amount ofany currently outstanding performance or surety bonds will be called. TheCompany believes that all work required to be completed at this time under thebonding agreements has been completed and, therefore, draws upon these bonds,if any, will not have a material effect on the Company’s financial position,results of operations or cash flows.

 

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*Legal Proceedings*

 

*Other Litigation*

 

There are various lawsuits and claims pending against the Company andcertain subsidiaries. In the opinion of the Company’s management, ultimateliability, if any, will not have a material adverse effect on the Company’sfinancial condition or results of operations.

 

*California Department of Toxic Substances Control*

 

In October 2006, the California Department of Toxic SubstancesControl (“DTSC”) filed a civil complaint against the Company’s HearthsideResidential Corp. subsidiary (“HRC”) in the Federal District Court for theSouthern Division of the Central District of California The DTSC’s complaintrequests that HRC pay for approximately $1.0 million of costs incurred bythe DTSC, together with interest on that amount, primarily in connection withthe oversight and remediation of PCB contamination found on residentialproperties never owned by HRC adjacent to a 43-acre site where HRC completedthe removal of PCB contaminated soil during September 2005. HRC’sremediation process was approved by the DTSC in December 2005 when itissued a final acceptance of the remediation work. The complaint also seeks anorder for HRC to pay any future costs which may be incurred in connection withfurther remediation, together with court costs and attorney’s fees.

 

Since May 2004, HRC has received invoices from DTSC seekingreimbursement for these costs; however, HRC contends, based upon advice ofcounsel, that it is not responsible for such costs because neither HRC nor anyaffiliate ever developed or built the neighboring residential properties,neither HRC nor any affiliate generated the contamination, the contaminationdid not emanate from the 43-acre site that HRC remediated, and, even if thecontamination did emanate from the 43-acre site, it did not do so while HRCowned the site. Furthermore, HRC has also disputed such charges due to the factthat DTSC improperly submitted its bill. The Company’s subsidiary is vigorouslydefending itself in this matter. Therefore, the Company has not accrued for anyof DTSC’s approximately $1.0 million of claims related to theseresidential properties.

 

Prior to the commencement of the trial that was scheduled forDecember 2008, the District Court ruled that HRC can be held liable as a “currentowner” of the site under applicable law. HRC applied to have that rulingcertified for appeal. In March 2009, the Ninth Circuit Court of Appealgranted permission to hear HRC’s appeal. Oral arguments were heard by the courton June 9, 2010. In July 2010, the Ninth Circuit Court of Appeal ruled againstHRC, establishing a new precedent in the Ninth Circuit that HRC is consideringpetitioning the United States Supreme Court for review.  A status conference has been set for August23, 2010 before the United States District Court to discuss the Ninth Circuitruling and set a trial date within 30 to 60 days.

 

*Corporate Indemnification Matters*

 

The Company and its former affiliates have, through a variety oftransactions effected since 1986, disposed of several assets and businesses,many of which are unrelated to the Company’s current operations. By operationof law or contractual indemnity provisions, the Company may have retainedliabilities relating to certain of these assets and businesses. There isgenerally no maximum obligation or amount of indemnity provided for suchliabilities. A portion of such liabilities is supported by insurance or byindemnities from certain of the Company’s previously affiliated companies. TheCompany believes its consolidated balance sheet reflects adequate reserves forthese matters.

 

**Note 11— Stockholders’ Equity**

 

Asof June 30, 2010, total stockholders’ equity is $23.3 million, reflecting beginningstockholders’ equity of $33.4 million and net loss of $10.1 million during thesix months ended June 30, 2010.

 

**Note 12— Stock Plan**

 

*1993 Stock Option/Stock Issuance Plan*

 

The 1993 Stock Option/Stock Issuance Plan (“1993 Plan”) was approved atthe 1994 Annual Meeting of Stockholders, reserving 7.5 million shares eachof Series A Preferred Stock and Class A Common Stock for issuance toofficers, key employees and consultants of the Company and its subsidiaries andthe non-employee members of the Board of Directors (the “Board”). OnApril 28, 1997, in connection with the Recapitalization, a new class ofCommon Stock replaced the Series A Preferred Stock and Class A CommonStock, and the Compensation Committee of the Board authorized the grant ofstock options for 759,984 shares, equivalent at that time to 6% of the Company’sfully diluted equity, for certain directors and officers. At the May 2004and June 2006 stockholder meetings, the stockholders of the Companyauthorized an additional 150,000 and 250,000 stock options, respectively, forthe 1993 Plan, resulting in total authorized grants of 1,159,984.

 

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During the six months ended June 30, 2010 and 2009, the Company issueda total of zero and 125,000 shares, respectively, of its common stock to threeindependent directors under the Director Fee Program, which is a component ofthe 1993 Plan. The Company is currently prohibited from issuing shares due tothe Chapter 11 Cases. The 2009 restricted shares vested at a rate of 25% perquarter during 2009.

 

The Company did not grant any options during the six months ended June30, 2010 and 2009. Pursuant to ASC 718-10, “*Compensation — StockCompensation*,” the Company recorded zero and $35,000 of compensationexpense during the six months ended June 30, 2010 and 2009, respectively, whichis reflected in additional paid-in capital.

 

A summary of the status of the Company’s 1993 plan for the six monthsended June 30, 2010 follows:

 
| ** **                              | ** ** | **Number of  Options** | ** ** | **Weighted-Average  Exercise  Price** | ** ** | **Weighted-Average  Remaining  Life** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| Outstanding, January 1             |       | 17,500                      |       | $                                     | 21.58      | (a)                                   |       |   |
| Granted                                 |       | —                      |       | $                                     | —     |                                  |       |   |
| Exercised                               |       | —                      |       | $                                     | —     |                                  |       |   |
| Outstanding, June 30                    |       | 17,500                      |       | $                                     | 21.58      | (a)                                   | 5.60 years |   |
|                                    |       |                        |       |                                  |       |                                  |       |
| Fully vested and exercisable at June 30 |       | 17,500                      |       | $                                     | 21.58      | (a)                                   | 5.60 years |   |
|                                    |       |                        |       |                                  |       |                                  |       |
| Available for future grants at June 30  |       | 221,794                     |       |                                  |       |                                  |       |

 

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(a)           Adjusted for specialdividend of $12.50

 

As of June 30, 2010, there were 17,500 options outstanding with aweighted-average exercise price of $21.58 (ranging from $13.35 to $25.99) and aweighted-average remaining life of 5.60 years. All outstanding stockoptions are fully vested. The aggregate intrinsic value of all outstanding,fully-vested and exercisable stock options at June 30, 2010 was zero.

 

The Company estimates the fair value of its stock options using theBlack-Scholes option pricing model (the “Option Model”). The Option Modelrequires the use of subjective and complex assumptions, including the option’sexpected term and the estimated future price volatility of the underlyingstock, which determine the fair value of the share-based awards. The Company’sestimate of expected term is determined based on the weighted-average period oftime that options granted are expected to be outstanding considering currentvesting schedules and the historical exercise patterns of the existing optionplan. The expected volatility assumption used in the Option Model is based onhistorical volatility on traded options on the Company’s stock in accordancewith guidance provided in ASC 718-10. The risk-free interest rate used in theOption Model is based on the yield of U.S. Treasuries with a maturity closestto the expected term of the Company’s stock options.

 

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**Item 2.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.**

 

This item contains forward-looking statements thatinvolve risks and uncertainties as set forth in “Cautionary Statements AboutForward-Looking Statements” at the beginning of this Quarterly Report onForm 10-Q. Actual results may differ materially from those indicated inthe forward-looking statements set forth below. Factors that may cause such adifference include, but are not limited to, those discussed in “Item 1A. RiskFactors” of our Annual Report on Form 10-K for the year endedDecember 31, 2009.

 

**Status of Chapter 11 Cases**

 

On October 27, 2009, California Coastal Communities, Inc. (“we”) andcertain of our direct and indirect wholly-owned subsidiaries (collectively withus, the “Debtors”) filed voluntary petitions (the “Chapter 11 Petitions”) forrelief under chapter 11 of title 11 (“Chapter 11”) of the United States Code(the “Bankruptcy Code”) in the United States Bankruptcy Court for the CentralDistrict of California (the “Bankruptcy Court”). The Chapter 11 Petitions arebeing jointly administered under the caption *In reCalifornia Coastal Communities, Inc.*, Case No. 09-21712-TA (the “Chapter11 Cases”). The primary purpose of the Chapter 11 Cases is to restructure thedebt obligations under our senior secured revolving loan (“Revolving Loan”) andour senior secured term loan (“Term Loan”) for which Wilmington Trust, FSBcurrently serves as agent for both loan syndicates. As of June 30, 2010, $81.7million in principal amount was outstanding on the Revolving Loan and $99.8million in principal amount was outstanding on the Term Loan.  Since the filing of the Chapter 11 Cases, weceased to make any payments of principal under both the Revolving Loan and theTerm Loan; however we continue to pay interest on the outstanding principalbalances at agreed upon non-default interest rates.

 

Weand the other Debtors continue to operate our businesses and manage ourproperties as “debtors-in-possession” under the jurisdiction of the BankruptcyCourt and in accordance with the applicable provisions of the Bankruptcy Codeand orders of the Bankruptcy Court. We have obtained the Bankruptcy Court’sapproval to, among other things, continue to pay critical vendors with lienrights, sell homes free and clear of all liens on an interim basis, use cashcollateral on an interim basis, honor homeowner warranties, meet payrollobligations and provide employee benefits. If the value of the Debtors’ assetsand operations become materially impaired, our ability to continue asdebtors-in-possession and to operate our business in the present mode could bejeopardized. During the three and six months ended June 30, 2010, we incurredcosts totaling $2.4 million and $3.7 million, respectively, associated with thereorganization and have incurred total reorganization costs of $5.0 millionthrough such date. We will continue to incur significant costs associated withthe reorganization which are expected to adversely affect the results of ourbusiness operations.

 

OnMarch 26, 2010, we filed a proposed disclosure statement and proposed jointplan of reorganization with the Bankruptcy Court and a court hearing on theadequacy of the disclosure statement was held on May 12, 2010. Subsequently, onJune 18, 2010, the Company obtained a financing commitment from Luxor CapitalGroup, LP (“Luxor”) to provide $184 million of new debt financing (the “NewFinancing”) to replace, if funded, our $81.7 million Revolving Loan and $99.8million Term Loan and to fund operations. In light of the New Financing, wefiled a revised disclosure statement and proposed joint plan of reorganizationwith the Bankruptcy Court on July 2, 2010. On July 28, 2010, we filed a furtheramended disclosure statement disclosing that we have agreed that the definitivedocumentation for the New Financing will require, as a condition to closing,that we obtain an additional $15 million of financing in the form of (i)indebtedness that would be subordinated to the New Financing; (ii) equity; or(iii) a combination of debt and equity (the “Additional Capital”). Prior to theamendment of the disclosure statement and plan, the Court had scheduled a planconfirmation hearing for August 12, 2010, which will be rescheduled.  The outside closing date for the NewFinancing is August 31, 2010. There can be no assurance that we and the otherDebtors will be able to successfully complete the New Financing and confirm,consummate and execute a plan of reorganization with respect to the Chapter 11Cases that is acceptable to the Bankruptcy Court and the creditors and otherparties in interest.

 

Wehave maintained business operations through the reorganization process. Ourliquidity and capital resources, however, are significantly affected by theChapter 11 Cases, which have resulted in various restrictions on our activities,limitations on financing and a need to obtain Bankruptcy Court approval forvarious matters. In particular, we and the other Debtors are not permitted tomake any payments on pre-petition liabilities without prior Bankruptcy Courtapproval. While the Bankruptcy Court has consistently approved all of ourrequests to continue wage and salary payments and other employment benefits toemployees, as well as other related pre-petition obligations, to continue toconstruct and sell homes, and to pay certain pre-petition trade claims held bycritical vendors with lien rights; there can be no assurance that our futurerequests will be approved. Our authorization to continue to use cash collateraland sell homes free and clear of liens is currently scheduled to terminate onSeptember 8, 2010.

 

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Underthe priority schedule established by the Bankruptcy Code, certain post-petitionand pre-petition liabilities need to be satisfied before general unsecuredcreditors and equity holders are entitled to receive any distribution. At thistime, it is not possible to predict with certainty the effect of the Chapter 11Cases on our business or various creditors, or when we and the other Debtorswill emerge from these proceedings. Future results will depend upon theconfirmation and successful implementation of a plan of reorganization. Thecontinuation of the Chapter 11 Cases, particularly if a plan of reorganizationis not timely confirmed, could further adversely affect our operations.

 

We depend on cash flows generated from operations and availableborrowing capacity to fund our Brightwater development, and to meet our debtservice and working capital requirements. However, our ability to continue togenerate sufficient cash flows has been and will continue to be adverselyaffected by continued difficulties in the homebuilding industry, continuedweakness in the California economy and negative publicity and prospectivehomebuyer concerns related to the Chapter 11 Cases. During the first six monthsof 2010, we generated seven net sales orders at Brightwater compared with 16net sales orders generated in the comparable period of 2009, and startedconstruction of a limited number of speculative homes which are in greaterdemand in today’s market than contract homes that are constructed over a fiveto seven month period.

 

Continuing negative conditions in the housing and credit markets giverise to uncertainty as to our present and future ability to meet our projectedhome sale closings and whether the Additional Capital, or modified or newfinancings, can be obtained in order for us to meet our debt obligations beforeand after we emerge from bankruptcy. There can be no assurance that we will besuccessful in any of these endeavors. While the national credit markets appearto be improving, there is limited availability of financing for smallbusinesses which presents significant uncertainty as to our ability to secureadditional financing and the terms of such financing if it is available. Thecurrent housing and jumbo mortgage markets also present significant uncertaintyas to our ability to achieve sufficient positive cash flow from operationsrequired to satisfy our debt obligations and meet financial covenantrequirements.

 

Basedon Brightwater sales in 2009 and the first half of 2010, we do not believe thatour cash, cash equivalents and future real estate sales proceeds will provide sufficientliquidity to meet our current debt obligations under the current terms of theexisting Revolving Loan Agreement and Term Loan Agreement as described in Notes5 and 6, in addition to our anticipated operating and project development costsfor Brightwater, and general and administrative expenses during the next12 months. These factors raise substantial doubt about our ability tocontinue as a going concern unless we are successful in replacing orrestructuring our Revolving Loan and Term Loan debt through confirmation of aplan of reorganization in the Chapter 11 Cases, including a plan thatimplements the New Financing and Additional Capital. Our Consolidated FinancialStatements set forth above do not include any adjustments that might result fromthe outcome of this uncertainty.

 

*NasdaqDelisting*

 

OnApril 27, 2010 our common stock was suspended from trading on the Nasdaq StockMarket because we had not emerged from the Chapter 11 process by April 26 and,on April 27, 2010 our common stock commenced trading in the OTCQB marketplaceunder the symbol “CALCQ.”  Our commonstock was officially delisted on June 21, 2010. The trading of our common stockin the over-the-counter market rather than on Nasdaq may negatively impact thetrading price and the levels of liquidity available to our stockholders. Inaddition, securities that trade over-the-counter are not eligible for marginloans and will make our common stock subject to the provisions of Rule 15g-9 ofthe Securities Exchange Act of 1934, as amended, commonly referred to as the “pennystock rule.”

 

Wehave filed an application with Nasdaq seeking the relisting of our securitieson The Nasdaq Stock Market following our emergence from the Chapter 11process.  In that regard, all companies,whether listed on Nasdaq or not, are required to satisfy the initial listingrequirements upon emergence from a Chapter 11 process to qualify forlisting.  Given that the cost of tradingon the OTCQB is substantially less than trading on Nasdaq and the trading,volume and liquidity of our common stock does not appear to have been impairedsince it commenced trading in the OTCQB marketplace, we are considering whetherto remain on the OTCQB following emergence from the Chapter 11 process.

 

**Overview ofCalifornia Coastal Communities, Inc. and Recent Industry Events.**

 

We are a residential land development and homebuilding company withproperties owned or controlled primarily in Orange County, California and alsoin Lancaster in Los Angeles County. Our primary asset is a 356-home luxurycoastal community known as Brightwater in Huntington Beach, California. Ourprincipal activities include:

 

·                  obtaining zoning and otherentitlements for land we own or for third parties under consulting agreements;

 

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·                  improving the land forresidential development; and

 

·                  designing, constructing andselling single-family homes in Southern California.

 

Once our residential land is entitled, we may build homes, sellunimproved land to other developers or homebuilders, sell improved land tohomebuilders, or participate in joint ventures with other developers, investorsor homebuilders to finance and construct infrastructure and homes. The majorityof our homes are designed to appeal to move-up homebuyers and are generallyoffered for sale in advance of their construction.

 

In view of the continuing significant economic downturn in the housingmarket, during the remaining six months of 2010 our new home construction willbe limited to our 356-home Brightwater project located on the Bolsa Chica mesain Huntington Beach, California.

 

During the remaining six months of 2010, our primary goals will be to:

 

·                  have our plan ofreorganization to refinance our debt obligations confirmed by the BankruptcyCourt as soon as possible, which would enable us to emerge from Chapter 11bankruptcy during 2010; and

 

·                  continue constructing,selling and delivering homes at Brightwater.

 

There can be no assurance that we will accomplish, in whole or in part,all or any of these strategic goals or any other strategic goals oropportunities that we may pursue.

 

Our total revenues for the three months ended June 30, 2010 and 2009 were$9.1 million and $10.5 million, respectively and $12.1 million and $23.3million for the six months ended June 30, 2010 and 2009 respectively.  For the three months ended June 30, 2010 and2009, we delivered eight and 12 homes, respectively. Our total assets as ofJune 30, 2010 and December 31, 2009 were $243.0 million and $249.9million, respectively, with Brightwater and other nearby propertiesconstituting $232.1 million (96% of total assets) and $234.8 million (94% oftotal assets), respectively. Our homebuilding subsidiary, HearthsideHomes, Inc., has delivered over 2,300 homes to families throughoutSouthern California since its formation in 1994.

 

Prior to obtaining the Coastal Development Permit for our Brightwaterproject in December 2005, we historically maintained a minimal amount ofleverage. In September 2006, we obtained $225 million of debtfinancing, as described in Notes 5 and 6 to the Consolidated FinancialStatements, which provided $100 million for Brightwater construction and$125 million to fund a $12.50 per share special dividend paid to ourstockholders in September 2006. As of June 30, 2010, we had$204.0 million of debt against $23.3 million of book equity.

 

We were formed in 1988 and our executive offices are located at 6Executive Circle, Suite 250, Irvine, California 92614. Our website addressis http://www.californiacoastalcommunities.com and our telephone number is(949) 250-7700. Through our website we make available our annual report onForm 10-K, quarterly reports on Form 10-Q, current reports onForm 8-K, and amendments to these reports filed or furnished pursuant toSection 13(d) or 15(d) of the Securities Exchange Act of 1934 assoon as reasonably practicable after they are filed with, or furnished to, theSecurities and Exchange Commission. Copies of our annual report onForm 10-K, quarterly reports on Form 10-Q, current reports onForm 8-K, and amendments to these reports are available free of chargeupon request. In addition, at our website: http://www.californiacoastalcommunities.com,we post copies of our Securities and Exchange Commission filings and pressreleases, as well as current versions of our code of ethics and businessconduct, audit committee charter and nominating committee charter.

 

**HomebuildingOutlook and Operating Strategy**

 

The financial crisis and economic recession that worsened in 2008 andexacerbated the existing downturn in the homebuilding market persistedthroughout 2009 and has continued through the second quarter of 2010.Specifically, the credit markets and the mortgage industry experienced a periodof unparalleled turmoil and disruption characterized by bankruptcy, declininghome prices and restrained demand, low consumer confidence, high unemployment,financial institution failure, consolidation and an unprecedented level ofintervention by the United States federal government. This disruption on thecredit markets has made it more difficult for homebuyers to obtain acceptablefinancing, particularly for jumbo-mortgages. In addition, the supply of new andresale homes in the marketplace remained excessive for the levels of consumerdemand, particularly given the supply created by record numbers of foreclosedhomes which are being offered at 

 

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substantiallyreduced prices. These pressures in the marketplace resulted in the use ofincreased sales incentives and price reductions in an effort to generate salesand reduce inventory levels by us and our competitors throughout 2009 and thefirst half of 2010. While there have been signs of improvement in the economyand financial markets during the first half of 2010, weakness in thehomebuilding environment continued as unemployment remains at very high rates,and is expected to continue throughout the year, and could intensify,particularly as government programs supportive of housing markets areterminated or reduced or expire.

 

The entire homebuilding industry has experienced larger thananticipated declines in sales, which we believe were further exacerbated by ageneral hesitation in the national and global markets due to the oil spill inthe Gulf of Mexico, the uncertainty of the European financial system and thedeclines in the stock market. Concern about the state of the economy and thejob market continues to negatively affect consumer confidence, as unemploymentrates continued to rise throughout 2009 in almost all of the metropolitan areastracked by the U.S. Department of Labor. The unemployment rate in Californiawas 12.2% at the end of the second quarter of 2010 compared with 11.2% at theend of the second quarter of 2009, while the unemployment rate in Orange Countywas 9.5% in June 2010 compared with 9.2% in June 2009. We believe that as longas these high unemployment rates continue, they will be one of the key barriersto commitment to a home-buying decision for our potential customers and willcontinue to impact the sales pace of the industry as a whole.

 

These adverse conditions have now persisted to varying degrees sincethe beginning of 2006 and their impact is reflected in our results for thefirst halves of 2010 and 2009.  Webelieve that the weak demand we are experiencing, particularly for homes over$1.5 million, reflects the excess supply of higher end homes in the coastalHuntington Beach market as well as homebuyers’ reluctance to make a purchasingdecision until they are comfortable that home price declines are near bottom,that economic conditions have stabilized and that our company will successfullyemerge from Chapter 11. However, the inventories of resale homes in theHuntington Beach coastal zip codes have been declining, which reduces thesupply of resale homes with which Brightwater may compete, and thejumbo-mortgage market is showing signs of gradual improvement. There can be noassurance that these trends will continue.

 

During 2009, the California home-buyer tax credit enacted early in theyear (which did not contain income or first-time buyer restrictions and waslimited to new homes) boosted demand somewhat; however, the federal stimulusplan did not significantly impact sales at our Brightwater project due to itsincome and first-time buyer restrictions. As of August 31, 2009, all of the$100 million in California tax credits had been issued. On March 25, 2010, anadditional $200 million of funding was approved by the State of Californiawhich will provide up to a $10,000 credit to first-time homebuyers or thosepurchasing a newly built home starting May 1, 2010. As of August 2, 2010, theFranchise Tax Board is still accepting applications for the first-timehomebuyer credit and the new home credit. However, applications will no longerbe accepted when all of the funds have been allocated.

 

Our overall outlook is cautious given the significant negative factorsand trends noted above and the uncertainty as to when our served markets mayexperience a sustained recovery, and we believe a meaningful improvement inhousing market conditions will require a sustained decrease in unsold homes,price stabilization, reduced mortgage delinquency and foreclosure rates, andthe restoration of both consumer and credit market confidence that support adecision to buy a home. We cannot predict when these events may occur.  While we have begun to see some positivesigns that these negative trends in the overall economy are moderating, itremains uncertain when the housing market or the broader economy will experiencea meaningful recovery. We anticipate that the overhang of bank-owned homes willcontinue to bloat the market throughout 2010 as lenders seek to unload theirinventory of foreclosed homes. We expect that market conditions will remainchallenging and we expect that our operations may sustain periodic losses untilthe homebuilding industry and economy, as a whole, demonstrate a sustainedrebound. Further, until we are able to refinance or restructure our RevolvingLoan and Term Loan debt through the Chapter 11 Cases, prospective buyers mayremain reluctant to purchase a Brightwater home and we may continue toexperience slower sales.

 

We maintain relationships with various mortgage providers and, with fewexceptions, the mortgage providers that furnish our customers with mortgagescontinue to issue new commitments. Our buyers generally have been able toobtain adequate financing but the number of potential home buyers that canqualify under the tightened lending standards has diminished. The availabilityof certain mortgage financing products continues to be constrained due toincreased scrutiny of once commonly-used mortgage products such as sub-prime,Alt-A, and other non-prime mortgage products. Further, throughout 2009, theinterest rates on jumbo mortgages were significantly greater than interestrates on conforming mortgages, with spreads approximating 1% compared withhistorical spreads in the range of only .25% to .35%. As of July 2010, thespread has narrowed to approximately .50% to .90%. Mortgage market liquidityissues and more stringent underwriting criteria have impeded some of our homebuyers from closing escrow, while others have found it more difficult to selltheir existing homes as their buyers face the problem of obtaining a mortgage.Because we cannot predict the short-and long-term liquidity of the creditmarkets, we continue to caution that, with the uncertainties in these markets,the pace of home sales could remain depressed or slow further until thesemarkets improve.

 

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In response to the ongoing crisis in the housing market and nationalcredit markets, during the first six months of 2010 we:

 

·                  continued offeringincentives for all of our homes in order to reduce inventory at Brightwater;and

 

·                  filed an amended disclosurestatement and proposed joint plan of reorganization for relief under Chapter 11in the Bankruptcy Court in order to complete the New Financing to replace theapproximately $182 million of Brightwater indebtedness under the Revolving Loanand the Term Loan and to pay certain costs of exiting the Chapter 11 process.

 

We expect to continue operations at only the four Brightwater communitiesuntil we see reasonable signs of a housing market recovery. If marketconditions decline further, we may need to take additional charges forinventory impairments in future quarters. In addition, we expect that ourresults for 2010 will be adversely affected by the costs of restructuring ourdebt through the Chapter 11 Cases. Our results could also be adversely affectedif general economic conditions do not improve further or deteriorate, ifconsumer confidence remains weak or declines further, if job losses continue oraccelerate, if foreclosures or distressed sales increase, or if consumermortgage lending becomes less available or more expensive, any or all of whichwould further diminish the prospects for a recovery in housing markets.

 

We believe that stability in the credit and capital markets and aneventual renewal of confidence in the national economy will play a major rolein any turnaround in the homebuilding and mortgage lending industries. We alsobelieve that a meaningful improvement in housing market conditions will requirethe restoration of consumer and credit market confidence that will support adecision to buy a home, which will in turn require a sustained decrease ininventory levels, price stabilization and reduced foreclosure rates.

 

As the housing market downturn persists, we will continue to adjust andreevaluate our operating strategy in an effort to reduce standing inventorieswhile monitoring our margins and liquidity. Recognizing the challengespresented by the downturn in the homebuilding market, our current operatingstrategy includes:

 

·                  continuing to adjust ourcost structure to today’s market conditions by controlling our headcount andoverhead and rebidding subcontracts and materials in line with reduced demand;

 

·                  exercising tight controlover cash flows;

 

·                  changing sales and marketingefforts to generate additional traffic;

 

·                  offering incentives andprice reductions to reduce standing inventories and achieve acceptable levelsof sales volume and cash flow;

 

·                  continuing to limitconstruction starts to align product available for sale with sales activity;and

 

·                  seeking to balance ourshort-term goal of selling homes in a depressed market and our long-term goalof maximizing the value of our communities.

 

During the first six months of 2010 and 2009, we delivered 10 and 19(including 14 Brightwater) homes, respectively. As of August 2, 2010, oneadditional home has been delivered, bringing year-to-date deliveries to 11homes, and six additional homes are in escrow, as discussed further under Item1—Business—Our Current and Future Homesites above.

 

Despite the challenges of the current California homebuilding market,we believe the potential for our Brightwater project remains high. Brightwaterhas not been immune to the effects of the unstable mortgage and housingmarkets; however, prior to our bankruptcy filing that impact appeared lesssevere than the weakness we have seen in our inland markets. We believe thatthe reduced impact is a result of Brightwater’s superior coastal location, theextremely limited supply of new homes on the coast of Southern California andthe absence of significant competition from other homebuilders in theHuntington Beach market due to the lack of available land for the developmentof new single family detached homes. We believe that Brightwater is in a locationthat is difficult to replace and in a market where approvals are increasingly 

 

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difficultto achieve. We also believe that Brightwater has substantial embedded valuethat should not be sacrificed under current depressed market conditions but,rather, should be realized over time. Finally, we believe that Brightwater’sdemographics remain strong due to the continuing regulation-induced constraintson lot supplies and the significant number of affluent households along thecoast of Southern California. Therefore, we remain optimistic about continuingsales at Brightwater.

 

While we generated 31 net sales orders in the first nine months of2009, we generated only two net sales orders at Brightwater during the fourthquarter of 2009 and seven net sales orders during the first half of 2010. Webelieve the deceleration in sales pace for the fourth quarter of 2009 and thefirst half of 2010 primarily reflects the negative impact of the Chapter 11announcement in October 2009.  Weanticipate that sales pace will continue to be negatively impacted until wesuccessfully implement a Chapter 11 plan of reorganization.

 

We expect that market conditions may continue to be challengingthroughout 2010, as unemployment rates remain elevated, foreclosure activitycontinues to be significant and consumer confidence continues to be eroded.Although substantially reduced home prices and relatively low consumer mortgageinterest rates have improved housing affordability, many potential homebuyersremain tepid about purchasing a home in this unstable economic environment.This demand-side dynamic, in conjunction with a high level of foreclosures, issustaining the oversupply of unsold new and existing homes and competitivepricing pressures that have generated the extremely challenging conditions ourindustry has experienced since the beginning of 2006.

 

While it is difficult to predict when a housing market and economicrecovery will occur, we believe we have responded with the right strategies tothe current and expected near-term housing market environment. We continue toevaluate additional operating and financing strategies to position ourselvesfor future opportunities. Longer term, we believe favorable demographics andpopulation growth in Southern California and a continuing desire for homeownership will drive demand for new homes in our markets, which will allow usto capitalize on the recovery in those markets when it occurs.

 

In the ordinary course of doing business, we must make estimates andjudgments that affect decisions on how we operate and on the reported amountsof assets, liabilities, revenues and expenses. These estimates include, but arenot limited to, those related to impairment of assets; capitalization of coststo inventory; cost of sales including estimates for financing, warranty, andother costs; and income taxes. We base our estimates on historical experience andon various other assumptions that are believed to be reasonable under thecircumstances. On an ongoing basis, we evaluate and adjust our estimates basedon the information then currently available. Actual results may differ fromthese estimates, assumptions and conditions.

 

Finally, our operating results during 2010 could be adversely affectedif housing, credit market, or general economic conditions deteriorate, if joblosses accelerate, if consumer mortgage lending becomes less available or moreexpensive, or if consumer confidence continues to fall, any or all of whichwould further diminish the prospects for a recovery in the housing market. Webelieve that there will not be a meaningful improvement in the housing marketuntil there is a sustained decrease in inventory levels, price stabilization,reduced foreclosure rates, greater availability of jumbo-mortgage financing,and the restoration of consumer confidence that can support a decision to buy ahome.

 

**Our Current and Future Homesites**

 

Our homebuilding operations include active projects in the HuntingtonBeach area of Southern California.  Wedelivered ten homes (five Trails, one Sands, three Cliffs and one Breakers)during the six months ended June 30, 2010, compared with nineteen deliveries(four Trails, four Sands, two Cliffs, four Breakers and five inland projectshomes) during the comparable period in 2009. We acquired no single-familyresidential lots during the six months ended June 30, 2010 and 2009 and we haveno contracts to acquire land or lots.

 

The following chart describes our current projects, their location andour lot and standing home inventories as of June 30, 2010:

 
| **Project**                        | ** ** | **Location**     | ** ** | **Commenced  Sales** | ** ** | **Models********(b)** | ** ** | **Backlog** | ** ** | **Standing  Inventory** | ** ** | **Specs Under  Construction** | ** ** | **Remaining  Lots** | ** ** | **Total Lot  Inventory** | ** ** |
|------------------------------------|------------|------------------|------------|----------------------|------------|-----------------------|------------|-------------|------------|-------------------------|------------|------------------------------------|------------|---------------------|------------|-------------------------------|------------|
| Brightwater  in Orange County (a): |       |             |       |                 |       |                  |       |        |       |                    |       |                               |       |                |       |                          |       |
| The  Trails                        |       | Huntington Beach |       | 2007                 |       | 4                     |       | 2           |       | 2                       |       | 3                                  |       | 17                  |       | 28                            |       |
| The  Sands                         |       | Huntington Beach |       | 2007                 |       | 4                     |       | 1           |       | 3                       |       | 2                                  |       | 52                  |       | 62                            |       |
| The  Cliffs                        |       | Huntington Beach |       | 2008                 |       | 4                     |       | 3           |       | 1                       |       | —                             |       | 89                  |       | 97                            |       |
| The  Breakers                      |       | Huntington Beach |       | 2008                 |       | 5                     |       | —      |       | 3                       |       | 1                                  |       | 87                  |       | 96                            |       |
| *Subtotal—Orange County*      |       |             |       |                 |       | 17                    |       | 6           |       | 9                       |       | 6                                  |       | 245                 |       | 283                           |       |
| Lancaster:                         |       |             |       |                 |       |                  |       |        |       |                    |       |                               |       |                |       |                          |       |
| Unimproved  lots                   |       | Lancaster        |       | (c)                  |       | —                |       | —      |       | —                  |       | —                             |       | 73                  |       | 73                            |       |
| *Total—All Projects*          |       |             |       |                 |       | 17                    |       | 6           |       | 9                       |       | 6                                  |       | 318                 |       | 356                           |       |

 

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(a)          Land acquired in 1970;commenced construction in 2006.

(b)         We sold our 17 Brightwatermodels to an independent third-party investor on December 31, 2008 andleased them back; however, the lease transaction is accounted for as afinancing and therefore those homes are included in our home inventories.

(c)          To be determined subject tomarket conditions.

 

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As of June 30, 2010, we had standing inventory of nine Brightwaterhomes. During the six months ended June 30, 2010, net new orders at Brightwaterdecreased to seven homes compared with 16 homes during the comparable period in2009 due to the negative impact of our Chapter 11 bankruptcy on buyerconfidence, a weak economic environment, and the absence of sales activity atour inland projects compared with the first half 2009. Due to the close out ofall inland projects during 2009, backlog of inland homes as of June 30, 2010was zero compared with eight homes as of June 30, 2009. During the first halfof 2010 we had no sales of inland homes compared with 10 during the first halfof 2009. Cancellations as a percentage of new orders were 42% during the sixmonths ended June 30, 2010, compared with approximately 16% during thecomparable period in 2009 with the higher cancellation rate in the first halfof 2010 reflecting the negative impacts of the general economy and ourcontinuing Chapter 11 bankruptcy process. Backlog for Brightwater as of June30, 2010 decreased to six homes compared with eight homes as of June 30, 2009.

 

*Brightwater at Bolsa Chica*

 

Brightwater is our coastal Orange County residential community, locatedon 105 acres of the Bolsa Chica mesa in the City of Huntington Beach,approximately 35 miles south of downtown Los Angeles. Brightwater was annexedinto the City of Huntington Beach in 2008. Brightwater offers a broad mix ofhome choices averaging 2,860 square feet and ranging in size from 1,710 squarefeet to 4,339 square feet. Located near Pacific Coast Highway and overlookingthe Pacific Ocean, Huntington Harbor and the restored 1,300-acre Bolsa ChicaWetlands, 63 of the 356 homes at Brightwater will have unobstructed oceanand/or wetlands views.

 

Brightwater is the largest property in our portfolio and, along withother nearby properties (including a five-acre parcel in the process ofentitlement), comprises substantially all of our real estate inventories as ofJune 30, 2010. This project is located on one of the last large undevelopedcoastal properties in Southern California. Brightwater is bordered on the northand east by residential development in the City of Huntington Beach andHuntington Harbor, to the south by open space and the 1,300-acre Bolsa Chicawetlands, and to the west by 120 acres of publicly-owned conservation land andopen space on the lower bench of the Bolsa Chica mesa, Pacific Coast Highway,Bolsa Chica State Beach, and the Pacific Ocean. Brightwater also has 37 acresof open space and conservation area.

 

We completed construction of eight model homes at The Trails and TheSands neighborhoods in July 2007, held a grand opening in August 2007and delivered the first nine homes in December 2007. DuringJanuary 2008, we completed construction of nine additional model homes forThe Cliffs and The Breakers and in February 2008 began selling homes tobuyers who previously registered on our priority list. We held a grand openingfor these neighborhoods in March 2008. These homes are larger than The Trails andThe Sands, ranging from 2,724 to 4,339 square feet. We began delivering homesat The Cliffs and The Breakers during the third quarter of 2008. As of June 30,2010, we have delivered an aggregate of 73 homes (excluding the 17 model homes)at Brightwater, including 34, 17, 12, and 10 homes at The Trails, The Sands,The Cliffs, and The Breakers, respectively.

 

Key facts and assumptions regarding the Brightwater development projectinclude the following:

 

·                  Brightwater is expected toconsist of 356 homes, including 106 homes at The Breakers, 109 homes at TheCliffs, 79 homes at The Sands and 62 homes at The Trails.

 

·                  There are 63 homes atBrightwater which will have unobstructed views of the Pacific Ocean and/or theBolsa Chica wetlands, including 36 homes at The Breakers (five delivered todate), 25 homes at The Cliffs and two homes at The Sands.

 

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·                  Build-out of productionhomes, which is subject to market conditions, is currently expected to takeapproximately five years and be completed in 2014 or 2015.

 

·                  Costs to improve the lotsfrom their raw condition to finished lots, including County permits, Cityannexation fees and school fees, approximate $200,000 per lot. As of June 30,2010, approximately 77% of these lot improvement costs have already beenincurred.

 

·                  The direct costs (excludingindirect costs such as supervision, overhead, sales and marketing, warranty,insurance, etc.) of building homes at Brightwater are currently expected torange from approximately $125 to $140 per square foot.

 

·                  Indirect costs are expectedto approximate 3% of sales revenues.

 

·                  Based on current sales priceand cost projections, the various Brightwater products are currently expectedto generate gross margins of approximately 4% to 21%. Gross margins for thelarger homes at The Cliffs and The Breakers are currently expected toapproximate 12% to 21%, while gross margins at The Trails and The Sands arecurrently expected to approximate 4% to 13%. The decrease in expected marginsreflects expected increases in interest rates in connection with refinancing orrestructuring our debt, price reductions required to be competitive under currentmarket conditions, additional incentives to sell standing inventory and greateruse of third-party real estate brokers.

 

The estimation process involved in the determination of value isinherently uncertain because it requires estimates as to future events andmarket conditions. This estimation process assumes our ability to completedevelopment and disposition of our real estate inventories in the ordinarycourse of business based on management’s present plans and intentions.Economic, market, and environmental conditions may affect our development andmarketing plans. The development of Brightwater depends upon various factors.Accordingly, the amount ultimately realized from the Brightwater project maydiffer materially from our current estimates and the project’s carrying value.

 

Deliveries for the three and six months ended June 30, 2010 and 2009were as follows:

 
| ** **              | ** ** | ** **            | ** ** | **Deliveries**                         | ** ** |
|-------------------------|------------|-----------------------|------------|----------------------------------------|------------|
| ** **              | ** ** | ** **            | ** ** | **Three Months  Ended  June 30,** | ** ** | **Six Months  Ended  June 30,** | ** ** |
| ** **              | ** ** | **Location**          | ** ** | **2010**                               | ** ** | **2009** | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **              | ** ** | ** **            | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Brightwater             |       |                  |       |                                   |       |   |   |   |   |   |   |
| The Trails              |       | Huntington Beach |       | 5                                      |       | 4 |   | 5 |   | 4 |   |
| The Sands               |       | Huntington Beach |       | 1                                      |       | 3 |   | 1 |   | 4 |   |
| The Cliffs              |       | Huntington Beach |       | 2                                      |       | 1 |   | 3 |   | 2 |   |
| The Breakers            |       | Huntington Beach |       | —                                 |       | 1 |   | 1 |   | 4 |   |
|                    |       |                  |       | 8                                      |       | 9 |   | 10 |   | 14 |   |
| Inland Empire/Lancaster |       |                  |       |                                   |       |   |   |   |   |   |   |
| Completed Projects      |       | Various               |       | —                                 |       | 3 |   | — |   | 5 |   |
| * *                | * *   | * *              | * *   | * *                               | * *   | * * | * * | * * | * * | * * | * * |
| * *                | * *   | * *              |       | 8                                      |       | 12 |   | 10 |   | 19 |   |

 

*Huntington Beach.*  We completed construction of the first eightmodel homes for The Trails and The Sands products which range from 1,710 to2,160 square feet during July 2007 and opened for sales inAugust 2007. We completed construction of nine model homes for The Cliffsand The Breakers in January 2008 and began selling homes in February 2008.We delivered nine homes at an average price of $1.2 million, or $609 persquare foot during 2007 and 23 homes during 2008, at an average price of$1.4 million, or approximately $564 per square foot. We delivered 31 homesat an average price of $1.2 million (including three Breakers view homesaveraging $3.2 million), or approximately $539 per square foot, during the yearended December 31, 2009. During the six months ended June 30, 2010, wedelivered ten homes at an average price of $1.1 million, or approximately $464per square foot. As of August 2, 2010, six Brightwater homes (including twohomes with wetland and ocean views) are in escrow at an average price of $1.5million, or approximately $561 per square foot, and 14 additional homes arecompleted or under construction and have been released for sale.

 

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*The Trails and The Sands*

 

We delivered six homes at The Trails and The Sands during the sixmonths ended June 30, 2010 and generated $5.1 million in revenue and grossoperating margins of 1.3%. During the comparable period of 2009 we deliveredfour Trails and four Sands homes and generated $7.3 million in revenue andgross operating margins of 16.5%. We delivered one additional Trails homeduring July 2010 at a price of $850,000. Homes at The Trails and The Sands arepresently being offered at prices ranging from $798,000 to $1.0 million. As ofAugust 2, 2010, three homes are in escrow at The Trails and The Sands, fivehomes are completed and unsold, and four homes are under construction andunsold.

 

*The Cliffs and The Breakers*

 

We delivered four and six homes at The Cliffs and The Breakers duringthe six months ended June 30, 2010 and 2009, respectively, and generatedrevenue of $5.6 million and $14.5 million, respectively, and gross operatingmargins of 11.8% and 31.2%, respectively. Three of the six homes deliveredduring the first half of 2009 were view homes with an average sales price of$3.2 million. The decrease in margins reflects the absence of view premiums forthe four homes delivered during the first half of 2010, expected increases ininterest rates in connection with restructuring our debt, price reductions andincentives required to be competitive under current market conditions, andgreater use of third-party real estate brokers. Homes at The Cliffs and TheBreakers are presently being offered at prices ranging from $1.3 million to$3.0 million for 2,724 to 4,339 square foot homes. As of August 2, 2010,three homes are in escrow at The Cliffs and The Breakers, four homes arecompleted and unsold, and one home is under construction and unsold.

 

*The Ridge*

 

We are pursuing entitlement for 22 homes averaging 3,500 square feet inthe City of Huntington Beach near our existing Brightwater project. The City ofHuntington Beach City Council approved the project on July 6, 2010. Entitlementof these lots is subject to approval by the California Coastal Commission, andis currently expected to take two to three years.  We currently expect that an application torevise the Local Coastal Program will be submitted to the California CoastalCommission during 2010.

 

*Lancaster.*  In April 2005, we acquired 73 unentitledlots in the City of Lancaster in northern Los Angeles County through asubsidiary of Hearthside Homes, Inc. We have deferred the constructionstart for this 73-unit project, which has no recorded loan, until salesactivity in this market improves significantly. The tentative map for thisproject is prepared, but we have delayed filing for approval in order to deferthe entitlement fees required to be paid at the time of filing.

 

**CriticalAccounting Policies and Estimates**

 

In the preparation of the Consolidated Financial Statements, we appliedaccounting principles generally accepted in the United States of America. Theapplication of generally accepted accounting principles may require managementto make estimates and assumptions that affect the amounts reported in thefinancial statements and accompanying results. Listed below are those policiesand estimates that we believe are critical and require the use of complexjudgment in their application. In particular, our critical accounting policiesand estimates include the evaluation of the impairment of long-lived assets andthe evaluation of the probability of being able to realize the future benefitsindicated by our significant federal tax net operating losses, as discussedfurther in Notes 3, 4 and 9 to the Consolidated Financial Statements.

 

*Basis ofConsolidation*

 

Our Consolidated Financial Statements include our accounts and all ofour majority-owned and controlled subsidiaries and joint ventures. Certain ofour wholly-owned subsidiaries are members in joint ventures involved in thedevelopment and sale of residential projects and residential loan production.We currently have an interest in one inactive joint venture in which we have acontrolling or majority economic interest, and thus is controlled by us and isconsolidated with our financial statements. Our investments in unconsolidatedjoint ventures are accounted for using the equity method when we do not havevoting or economic control of the venture operations. All significantintercompany accounts and transactions have been eliminated in consolidation.

 

*Impairment of Long-Lived Assets*

 

During the three months ended June 30, 2010, we recorded animpairment charge of $6.0 million with respect to our Brightwater project. Thisdetermination was made based upon recent home sales activity in the marketplaceand other economic data which may or may not be representative of actual trendsin the economy. Our analysis also considered less conservative assumptionswhich were supported by historical analysis of significant factors in theevaluation. Although an impairment of the Brightwater project has been recorded,we believe that it is difficult to determine due to our extended period of timein Chapter 11, which has a negative impact on potential buyers of Brightwaterhomes. During the comparable periods in 2009, we recorded zero Brightwaterproject impairment charges and inland project impairment charges totaling zeroand $3.2 million, respectively.

 

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We assess the impairment of real estate inventories and otherlong-lived assets in accordance with ASC 360-10-35 which requires thatlong-lived assets be reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. Impairment is evaluated by comparing an asset’s carrying value tothe undiscounted estimated cash flows expected from the asset’s operations andeventual disposition. If the sum of the undiscounted estimated future cashflows is less than the carrying value of the asset, an impairment loss isrecognized based on the fair value of the asset. If impairment occurs, the fairvalue of an asset is deemed to be the amount a willing buyer would pay awilling seller for such asset in a current transaction. Additionally, asappropriate, we identify alternative courses of action to recover the carryingvalue of our long-lived assets and evaluate all likely alternatives under aprobability-weighted approach as described in ASC 360-10-35.

 

In making our determination to record a Brightwater project impairment,we have incorporated various market assumptions including those regarding homeprices, sales pace, sales and marketing costs, infrastructure and home-buildingcosts, and financing costs regarding real estate inventories in accordance withASC 360-10-35, in developing estimated future cash flows for impairment testingfor our real estate inventories. Our assumptions are based, in part, on generaleconomic conditions, the current state of the homebuilding industry,expectations about the short- and long-term outlook for the housing market, andcompetition from other homebuilders in the areas in which we build and sellhomes. These assumptions can significantly affect our estimates of future cashflows. For those communities deemed to be impaired, we determine fair valuebased on discounted estimated future cash flows using estimated absorptionrates for each community.

 

We evaluated our Brightwater project for impairment as of June 30, 2010,and determined that a $6.0 million impairment was indicated based on ourprojection of the project’s future cash flows, including projected revenues,costs and gross margin.  We based ourassumptions on our evaluation of projected prices while reflecting currentmarketing efforts, review of competitive home sales, characteristics of theHuntington Beach housing market, and current construction costs.  Our book basis in Brightwater of $227.0million as of June 30, 2010 reflects the $6.0 million impairment charge recordedduring the three months ended June 30, 2010 and a fair value adjustmentrecorded in September 1997 under “Fresh Start” accounting as well asdevelopment and construction costs incurred and reductions for costs of salesin conjunction with real estate sales since then.  Since 1997, we have recorded no other impairmentcharges for Brightwater, primarily due to the long holding period andsignificant increases in home prices since 1997, before the current challengingconditions and price depreciation of the past two years.

 

The most critical factors in our Brightwater analysis are projectedhome prices and direct construction costs, as they are affected by marketfactors such as home sale competition, the availability of financing for homepurchases and competition for direct construction goods and services.  Since opening for sales at Brightwater inAugust 2007, we have reduced prices and offered sales incentives in response tothe recent difficult conditions in the housing market. We have reflected theseprice reductions in our projections which reduced average future projectedgross margins for the project from approximately 30%-40% in 2007 to 6%-33% asof December 2009 and 4%-21% as of June 2010. The decrease in expected marginsalso reflects greater expected use of third-party real estate brokers,particularly in the near-term, and expected increases in interest rates inconnection with restructuring our debt.

 

Home prices and direct construction costs are the most critical factorsin our impairment analysis and we estimate that a 1% change in home prices ordirect construction costs would change gross margin by approximately .75% and..25%, respectively. Due to their subjective and interrelated nature, we cannotmeaningfully quantify the impact of potential changes for all of the factorsconsidered in our impairment analysis. While there is risk that additionalprice reductions may be necessary, it appears unlikely that any future pricereductions or direct construction cost increases would result in erosion of theentire positive cash flow that we are currently projecting and result in animpairment charge for this project. However, there can be no assurance in thatregard because economic and housing market conditions may continue to worsen orother events beyond our control may occur which could result in a change in ourassumptions.

 

In our analysis, we noted that the Brightwater project in HuntingtonBeach is in a mature housing market with very limited new home construction anda low supply of comparable resale homes with views or competitivefeatures.  Further, Huntington Beach hasconsistently outperformed other coastal Orange County cities with averagemarket times of four to six months compared with seven to eight months inneighboring coastal cities. Notably, since August 2009, supply at the $1.0million to $1.5 million level has declined from nine months to six months as ofJuly 2010. During the same time period, supply has declined from 21 months to19 months at the $2.0 million and above level. In January 2009, the City ofHuntington Beach’s credit rating was raised, reflecting the city’s built-outnature and expected economic resilience of the city’s households.  Huntington Beach is in coastal Orange Countywhich is the subject of two widely respected annual economic forecasts whichexpect an increase in median home prices in 2010 and an increase in demand dueto improved affordability.  Therefore,market data support our assumption that our Brightwater project in HuntingtonBeach will fare better than most surrounding Orange County communities andsignificantly better than projects in inland areas, resulting in reasonableexpectations of price increases in future years given the limited supply of newhomes along the coast of Southern California.

 

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In our impairment analysis of the Brightwater project, we also considerprojected construction and related costs and the availability of mortgagefinancing for our potential homebuyers. While mortgage financing for our homes is still challenging, 30-yearjumbo mortgage rates have decreased from a national average high of 8.4% inOctober 2008 to current rates ranging from 4.875% to 5.125% and lenders arebeginning to relax down payment requirements which were as high as 30% forjumbo loans in the Fall of 2009.  Withthe conforming loan maximum in Orange County continuing at $729,750, asignificant portion of our potential homebuyers are able to finance asubstantial portion of their home purchase at historically low mortgage ratesbelow 5.0 %.

 

The estimation process involved in the determination of value isinherently uncertain since it requires estimates as to future events and marketconditions. Such estimation process assumes the Company’s ability to completedevelopment and disposition of its real estate properties in the ordinarycourse of business based on management’s present plans and intentions. Economicand market conditions may affect management’s development and marketing plans.In addition, the implementation of such development and marketing plans couldbe affected by the availability of future financing for development andconstruction activities. Accordingly, the amount ultimately realized from suchproject may differ materially from current estimates and the project’s carryingvalue.

 

We believe that the accounting for the impairment of long-lived assetsis a critical accounting policy because the valuation analysis involves anumber of assumptions that may differ from actual results and the impact ofrecognizing impairment losses has been material to our Consolidated FinancialStatements. The critical assumptions in our evaluation of potential impairmentof real estate inventories included projected sales prices, anticipated salespace within each community, and applicable discount rates, any of which couldchange materially as economic conditions change.

 

*IncomeTaxes*

 

We account for income taxes on the liability method, in accordance withASC 740-10, “*Income Taxes*.”Deferred income taxes are determined based on the difference between thefinancial statement and tax bases of assets and liabilities, using enacted taxrates in effect in the years in which these differences are expected toreverse. The liability method requires an evaluation of the probability ofbeing able to realize the future benefits indicated by deferred tax assets. Avaluation allowance is established against a deferred tax asset if, based onthe available evidence, it is “more likely than not” that such asset will notbe realized. The realization of a deferred tax asset ultimately depends on theexistence of sufficient taxable income in either the carryback or carryforwardperiods under tax law. We evaluate on a quarterly basis, whether a valuationallowance should be established based on our determination of whether it is “morelikely than not” that some portion or all of the deferred tax assets will berealized. In our assessment, appropriate consideration is given to all positiveand negative evidence related to the realization of the deferred tax assets.This assessment considers, among other matters, the nature, frequency andmagnitude of current and cumulative income and losses, forecasts of futureprofitability, the duration of statutory carryback or carryforward periods, ourexperience with operating loss and tax credit carryforwards not expiringunused, and tax planning alternatives.

 

Our assessment of the need for a valuation allowance on our deferredtax assets includes assessing the likely future tax consequences of events thathave been recognized in our Consolidated Financial Statements or tax returns.We base our estimate of deferred tax assets and liabilities on current tax lawsand rates and, in certain cases, on business plans and other expectations aboutfuture outcomes. Changes in existing tax laws or rates could affect our actualtax results and our future business results may affect the amount of ourdeferred tax liabilities or the valuation of our deferred tax assets over time.

 

On October 27, 2009, we filed Chapter 11 Petitions in the BankruptcyCourt. Due to uncertainties regarding the resolution of our Chapter 11 Casesand our ability to utilize our NOLs in the future, during 2009 we recorded avaluation allowance for the remaining amount of our net deferred tax assets. Werecorded an additional valuation allowance of $3.4 million during the firsthalf of 2010 related to deferred tax assets generated during the first sixmonths of the year.

 

Due to uncertainties in the estimation process, particularly withrespect to changes in facts and circumstances in future reporting periods(carryforward period assumptions), it is reasonably possible that actualresults could differ from the estimates used in our historical analyses. Ourassumptions require significant judgment because the residential homebuildingindustry is cyclical and is highly sensitive to changes in economic conditions.Our current assessment of the need for a valuation allowance is primarilydependent upon utilization of tax net operating losses in the carryforwardperiod and our future projected income. If our results of operations are moreor less than projected and there is objectively verifiable evidence to supportthe realization of a different amount of our deferred tax assets, an adjustmentto our valuation allowance may be required to reflect greater expectedutilization.

 

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We remain subject to the general rules of Section 382 of theInternal Revenue Code, which limit the availability of net operating losses ifan ownership change occurs. If we were to experience another ownership change,the amount of net operating losses available would generally be limited to anannual amount equal to (i) the value of our equity immediately before theownership change, multiplied by the long-term tax-exempt rate (4.01% as ofAugust 2010) plus (ii) recognized built-in-gains, defined as those gainsrecognized within five years of the ownership change subject to an overalllimitation of the net unrealized built-in gains subject to a $10 millionminimum existing as of the ownership change date, if applicable. We estimatethat after giving effect to various transactions by stockholders who hold a 5%or greater interest in the company, we have experienced a three-year cumulativeownership shift of approximately 44% as of August 2, 2010, as computed inaccordance with Section 382. In the event of an ownership change, our useof our NOLs would be materially jeopardized.

 

On May 13, 2010, we reinstated a ban on acquisitions of additionalshares of our Common Stock, under certain circumstances, in order to preservethe tax benefits of our $163 million of NOLs. In accordance with provisions of our charter documents, unless we havepreviously consented in writing (i) no stockholder may acquire shares in anamount that would cause the stockholder to own 5% or more of the common stock;and (ii) no current 5% or greater stockholder may acquire any additional sharesof common stock.

 

All acquisitions of our common stock in violation of our charterprohibitions are null and void, and we are empowered to effectively reverse theeffect of any such acquisitions.  OurBoard of Directors may, but is not required to, entertain requests forpermission to exceed the limitations on stock acquisitions under circumstancesit determines are not likely to jeopardize our ability to preserve and use ourNOLs.

 

In connection with completing the New Financing, the utilization ofNOLs would be materially jeopardized.

 

*Homebuilding Revenues and Cost of Sales*

 

Our homebuilding operation generates revenues from the sale of homes tohomebuyers. The majority of these homes are designed to appeal to move-uphomebuyers and are generally offered for sale in advance of their construction.Sales contracts are usually subject to certain contingencies such as the buyer’sability to qualify for financing. Revenue from the sale of homes is recognizedat the close of escrow when title passes to the buyer and the earnings processis complete. As a result, our revenue recognition process does not involvesignificant judgments or estimates. However, we do rely on certain estimates todetermine the related construction costs and resulting gross margins associatedwith revenues recognized. The cost of sales is recorded based upon totalestimated costs within a subdivision and allocated using the relative salesvalue method. Our construction costs are comprised of direct and allocatedcosts, including estimated costs for future warranties and indemnities. Ourestimates are based on historical results, adjusted for current factors.

 

*Litigation Reserves*

 

We and certain of our subsidiaries have been named as defendants invarious cases arising in the normal course of business and regarding assets andbusinesses disposed of by us or our former affiliates. See Notes 8 and 10to our Consolidated Financial Statements beginning on page 5. We have reservedfor costs expected to be incurred with respect to these cases based uponinformation provided by our legal counsel. There can be no assurance that totallitigation costs actually incurred will not exceed the amount of such reserve.

 

**RecentAccounting Pronouncements**

 

Seediscussion regarding New Accounting Pronouncements in Note 3 to theConsolidated Financial Statements.

 

**Resultsof Operations**

 

Afterfiling the Chapter 11 Cases, we are required to periodically file variousdocuments with, and provide certain information to the Bankruptcy Court,including statements of financial affairs, schedules of assets and liabilities,and monthly operating reports in forms prescribed by Chapter 11, as well ascertain financial information on an unconsolidated basis. Such materials willbe prepared according to requirements of Chapter 11. While we believe thatthese documents and reports provide then-current information required underChapter 11, they are prepared only for the Debtors and, therefore, certainoperational entities are excluded. In addition, they are prepared in a formatdifferent from that used in our Consolidated Financial Statements filed underthe securities laws and they are unaudited. Accordingly, we believe that thesubstance and format do not allow meaningful comparison with our regularpublicly-disclosed Consolidated Financial Statements. Moreover, the materialsfiled with the Bankruptcy Court are not prepared for the purpose of providing abasis for an investment decision relating to our securities, or for comparisonwith other financial information filed with the Securities and ExchangeCommission (the “SEC”).

 

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Thefollowing tables set forth key operating and financial data for ourhomebuilding operations for the three and six months ended June 30, 2010 and2009.

 

**Backlog as of June 30**

 
| **Homes in Backlog** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|--------------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2010**                       | ** ** | **2009**                                 | ** ** | **Change**                                                      | ** ** | **2010** | ** ** | **2009** | ** ** | **Change** | ** ** | **2010** | ** ** | **2009** | ** ** | **Change** | ** ** |
| 6                              |       | 16                                       |       | (63                                                             | )%         | $ | 8.7 |   | $ | 13.0 |   | (33 | )% | $ | 1,442 |   | $ | 812 |   | 78 | % |
|                                |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Homes Delivered****Three Months Ended June 30**

 
| **Homes Delivered** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|--------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2010**                 | ** ** | **2009**                                 | ** ** | **Change**                                                      | ** ** | **2010** | ** ** | **2009** | ** ** | **Change** | ** ** | **2010** | ** ** | **2009** | ** ** | **Change** | ** ** |
| 8                        |       | 12                                       |       | (33                                                             | )%         | $ | 7.7 |   | $ | 10.5 |   | (27 | )% | $ | 963 |   | $ | 872 |   | 10 | % |
|                          |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Homes Delivered****Six Months Ended June 30**

 
| **Homes Delivered** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|--------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2010**                 | ** ** | **2009**                                 | ** ** | **Change**                                                      | ** ** | **2010** | ** ** | **2009** | ** ** | **Change** | ** ** | **2010** | ** ** | **2009** | ** ** | **Change** | ** ** |
| 10                       |       | 19                                       |       | (47                                                             | )%         | $ | 10.7 |   | $ | 23.3 |   | (54 | )% | $ | 1,070 |   | $ | 1,224 |   | (13 | )% |
|                          |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*ThreeMonths Ended June 30, 2010 Compared with the Three Months Ended June 30, 2009*

 

We reported revenues of $9.1 million and gross operating loss of $4.3million for the second quarter of 2010, compared with $10.5 million inrevenues and gross operating profit of $1.9 million for the second quarter of2009. Revenues of $9.1 million for the 2010 period include land sale revenuesof $1.4 million generated from the sale of land encumbered by an oil lease anda conservation easement. Revenues in the current period reflect deliveries ofeight Brightwater homes. The comparable period of the prior year reflectsdeliveries of 12 homes, including nine homes at Brightwater and three inlandhomes.

 

Homebuilding gross operating profit before impairment charges decreased$1.6 million from $1.9 million for the second quarter of 2009 to $300,000 forthe second quarter of 2010 as a result of delivering only eight homes atBrightwater which generated a 3.9% gross margin, compared with nine Brightwaterdeliveries and three inland deliveries which generated a 18.1% gross marginduring the comparable period in 2009. The decrease in gross margin reflectsexpected increases in interest rates in connection with refinancing orrestructuring our debt, as well as sales price reductions and incentivesoffered in response to the continuing difficult conditions in the housingmarket and greater use of third-party brokers. Gross operating loss for the second quarter of 2010 includes a $6.0million impairment charge related to our Brightwater project and land saleprofit of $1.4 million generated from the sale of land encumbered by an oillease and a conservation easement.

 

Reorganization costs of $2.4 million during the second quarter of 2010reflect legal and professional fees and other costs associated with the Chapter11 bankruptcy proceedings.

 

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*SixMonths Ended June 30, 2010 Compared with the Six Months Ended June 30, 2009*

 

We reported revenues of $12.1 million and gross operating loss of $3.9million for the first half of 2010, compared with $23.3 million in revenues andgross operating profit of $2.7 million for the first half of 2009. Revenues of$12.1 million in 2010 include land sale revenues of $1.4 million generated fromthe sale of land encumbered by an oil lease and a conservation easement.Revenues in the current period reflect deliveries of 10 Brightwater homes. Thecomparable period of the prior year reflects deliveries of 19 homes, includingfourteen homes at Brightwater (three of which were view homes) and five inlandhomes.

 

Homebuilding gross operating profit before impairment charges decreased$5.2 million from $5.9 million for the first half of 2009 to $700,000 for thefirst half of 2010 as a result of delivering only 10 homes at Brightwater whichgenerated a 6.5% gross margin, compared with 14 Brightwater deliveries and fiveinland homes which generated a 25.3% gross margin.  Gross operating loss for the first half of2010 includes a non-cash impairment charge of $6.0 million related to ourBrightwater project.  Gross operatingprofit for the first half of 2009 includes a non-cash impairment charge of $3.2million, reflecting a fair value write-down for an inland project in Beaumontwhich was disposed of on September 30, 2009. The decrease in gross marginreflects a change in the mix of homes delivered, including four Cliffs andBreakers homes and no view homes among the 10 homes delivered in the 2010period compared with six Cliffs and Breakers homes, including three view homesamong the 14 Brightwater homes delivered during the first half of 2009. Inaddition, the decrease in gross margin during the first half of 2010 reflectsexpected increases in interest rates in connection with refinancing orrestructuring our debt, as well as sales price reductions and incentivesoffered in response to the continuing difficult conditions in the housingmarket and greater use of third-party brokers. Gross operating profit for the first half of 2010 includes land saleprofit of $1.4 million generated from the sale of land encumbered by an oillease and a conservation easement.

 

Reorganization costs of $3.7 million during the first half of 2010reflect legal and professional fees and other costs associated with the Chapter11 bankruptcy proceedings.

 

The $800,000 decrease in interest expense compared with the first halfof 2009 primarily reflects the absence of various inland projects which weresold or disposed in 2009 for which we are no longer incurring period costs.

 

*PaymentsUnder Contractual Obligations*

 

Our purchase contracts which are made in the normal course of ourhomebuilding business for land acquisition and construction subcontracts aregenerally cancelable at will. Other contractual obligations including our taxliabilities, accrued benefit liability for a frozen retirement plan and otheraccrued pensions, home warranty reserves and contingent indemnity andenvironmental obligations are estimated based on various factors. Payments arenot due as of a given date, but rather are dependent upon the incurrence ofprofessional services, the lives of annuitants and other factors. Theestimation process involved in the determination of carrying values of theseobligations is inherently uncertain since it requires estimates as to futureevents and contingencies. We have provided additional disclosure below inPart II — Item 1 — Legal Proceedings, and in Note 10 to ourConsolidated Financial Statements above.

 

**Liquidityand Capital Resources**

 

OnSeptember 28, 2009, we received a notice of an event of default from the agentto the lending syndicate with respect to the loan-to-value covenant of theRevolving Loan that would give rise to the right to accelerate the indebtednessunder the Revolving Loan and Term Loan. In addition, on October 1, 2009, wereceived a notice of an event of default with respect to our nonpayment ofapproximately $1.7 million of principal that was due on September 30, 2009under the terms of the Revolving Loan that would also give rise to the right toaccelerate the indebtedness under the Revolving Loan and Term Loan. As of June30, 2010, $81.7 million and $99.8 million of principal was outstanding underthe Revolving Loan and Term Loan, respectively.

 

The filing of the Chapter 11 Petitions on October 27, 2009, alsoconstituted events of default under the Revolving Loan and the Term Loan thatcan trigger acceleration of the indebtedness. However, the filing of the Chapter 11 Petitions automatically stayedthose actions against us and the other subsidiary Debtors.  Under the terms of Bankruptcy Court orders,we have continued to pay interest on the outstanding principal balances of theRevolving Loan and the Term Loan at agreed upon non-default interest rates. OnJuly 28, 2010, the Bankruptcy Court approved a settlement agreement between theDebtors, the agent and the existing lenders that provided, among other things,that no default interest will be due and reduced the amount of legal andprofessional fees payable by the Debtors to the agent.

 

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While we are striving to repay the Revolving Loan and the Term Loanthrough the Chapter 11 Cases, unless we are successful in completing the NewFinancing or otherwise refinancing or amending and extending the terms of theRevolving Loan and Term Loan agreements, we do not believe that our cash, cashequivalents and future real estate sales proceeds will provide sufficient liquidityto meet our current debt obligations under the current terms of the existingRevolving Loan and Term Loan Agreements, in addition to meeting anticipatedoperating and project development costs for Brightwater, and general andadministrative expenses during the next 12 months. There can also be noassurance that the New Financing will be completed or that we will emerge fromthe Chapter 11 bankruptcy process as presently contemplated. These factors, andothers, raise substantial doubt about our ability to continue as a goingconcern. The Consolidated Financial Statements herein do not include anyadjustments that might result from the outcome of this uncertainty.

 

Year-over-yearchanges in the principal components of our liquidity and capital resources areas follows (in millions, except percentages):

 
| ** **                                      | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------|------------|--------------------------------|------------|
| ** **                                      | ** ** | **June 30,**                   | ** ** |
| ** **                                      | ** ** | **2010**                       | ** ** | **2009** | ** ** |
| Cash and cash equivalents                       |       | $                              | 6.3        |   | $ | 10.0 |   |
| Cash (used in) provided by operating activities |       | (2.6                           | )          | 7.7 |   |
| Cash provided by investing activities           |       | —                         |       | 0.4 |   |
| Cash used in financing activities               |       | —                         |       | (0.4 | ) |
|                                                 |            |                                |            |  |  |  |  |

 

The principal assets in our portfolio are residential lots which mustbe held over an extended period of time in order to be developed to a conditionthat, in management’s opinion, will ultimately maximize our return.Consequently, we require significant capital to finance our real estatedevelopment and homebuilding operations. Historically, sources of capital haveincluded loan facilities secured by specific projects and available internalfunds. Our unrestricted cash and cash equivalents as of June 30, 2010aggregated $6.3 million. Of this amount, the use of $5.0 million issubject to the Bankruptcy Court’s interim cash collateral order.

 

Since the filing of the Chapter 11 Cases we have only been payinginterest under the Term and Revolving Loans as we continue to seek to obtainthe Additional Capital required to complete the New Financing and obtainapproval of our plan of reorganization to replace or restructure our debt.

 

*June30, 2010 Compared with December 31, 2009*

 

Cash used in operating activities of $2.6 million for the firsthalf of 2010 primarily reflects investments in Brightwater of$11.9 million, general and administrative costs of $2.2 million andrestructuring costs of $3.7 million, which were partially offset by netproceeds from sales of $11.6 million and the increase in accounts payable andaccrued liabilities discussed below.

 

The $3.1 million increase in accounts payable and accrued liabilitiesreflects an increase of $1.8 million for accrued reorganization costs andincreases in accrued amounts for interest due on the Term and Revolving Loans,other professional fees and Brightwater project construction.

 

**OffBalance Sheet Financing**

 

In the ordinary course of business, we may enter into land optioncontracts in order to procure land for the construction of homes. The use ofsuch option agreements allows us to reduce the risks associated with landownership and development; reduce our financial commitments, including interestand other carrying costs; and minimize land inventories. Under such land optioncontracts, we will fund a specified option deposit or earnest money deposit inconsideration for the right to purchase land in the future, usually at apredetermined price. Our liability is generally limited to forfeiture of thenonrefundable deposits, letters of credit and other nonrefundable amountsincurred. As of June 30, 2010, we have no land option deposits and no thirdparty guarantees.

 

We also may acquire land and conduct residential constructionactivities through participation in joint ventures in which we hold less than acontrolling interest. Through joint ventures, we reduce and share our risk andalso reduce the amount invested in land, while increasing our access topotential future home sites. The use of joint ventures also, in some instances,enables us to acquire land which we might not otherwise obtain or access on asfavorable terms, without the participation of a strategic partner. While weview the use of unconsolidated joint ventures as beneficial to our homebuildingactivities, we do not view them as essential to those activities.

 

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Under the requirements of ASC 810, “*Consolidation*”(“ASC 810”), certain of our land option contracts may create a variableinterest for us, with the land seller being identified as a VIE. In compliancewith ASC 810, we analyze our land option contracts and other contractualarrangements and consider whether we should consolidate the fair value ofcertain VIEs from which we are purchasing land under option contracts. As ofJune 30, 2010, we had no deposits with VIEs.

 

**Impactof Inflation, Changing Prices and Economic Conditions**

 

Realestate and residential housing prices are affected by a number of factors,including but not limited to uncertainty by potential homebuyers in thestability of the United States and global economy, inflation or deflation,interest rate changes, competition and the supply of new and existing homes tobe purchased. Uncertainty in the stability of the national economy andsignificant volatility in the banking system and financial markets can, andhas, caused potential homebuyers to refrain from committing to make significantpurchases, including the purchase of new homes. In the event the volatility inthe banking system and financial markets continues to remain high and thenational economy does not stabilize in the near term, our ability to sell newhomes to potential homebuyers can be impacted negatively.

 

The long-term impact of inflation may affect us through increased costsfor land, land development, construction and overhead, as well as in increasedsales prices of our homes. Our land acquisition costs are generally fixed,therefore, increases or decreases in the sales prices of homes will affect ourprofits. The sales price of each of our homes is fixed at the time a buyerenters into a contract to acquire a home. Therefore, if we sell our homesbefore we begin construction, any inflation of costs in excess of thoseanticipated may result in lower gross margins, unless these increased costs arerecovered through higher sales prices.

 

Also, deflation can cause the market value of our land and constructedhomes to decline which could negatively impact our results of operations. Ifinterest rates increase, construction and financing costs, as well as the costof borrowings, could also increase, which can result in lower gross margins on homesales. Increases in home mortgage interest rates make it more difficult for ourcustomers to qualify for home mortgage loans, potentially decreasing home salesrevenue. Increases in interest rates also may affect adversely the volume ofmortgage loan originations. Increases in competition and the supply of unsoldnew and existing homes have had an adverse effect on our ability to generatenew home orders and maintain home orders in backlog, and have had a significantnegative impact on our results of operations and gross margins on home sales inour inland markets.

 

Interest rates, the length of time that land remains in inventory andthe proportion of inventory that is financed affect our interest costs. If weare unable to raise sales prices enough to compensate for higher costs, or ifmortgage interest rates increase significantly, affecting prospective buyers’ability to adequately finance home purchases, our revenues, gross margins andnet income would be adversely affected. Increases in sales prices, whether theresult of inflation or demand, may affect the ability of prospective buyers toafford new homes.

 

**Item 3.  Quantitative andQualitative Disclosures About Market Risk**

 

We utilize variable rate debt financing for acquisition, developmentand construction of homes. The interest rates on our debt approximate thecurrent rates available for secured real estate financing with similar termsand maturities, and as a result, their carrying amounts approximate fair value.While changes in interest rates generally may not impact the fair market valueof the debt instrument, they do affect our earnings and cash flows. Holding ourvariable rate debt balance constant as of June 30, 2010, each one pointpercentage increase in interest rates would result in an increase in variablerate interest incurred for the next 12 months of approximately$1.8 million.

 

We are exposed to market risks related to fluctuations in interestrates on our outstanding variable rate debt. We do not utilize swaps, forwardor option contracts on interest rates, or other types of derivative financialinstruments. We do not enter into or hold derivatives for trading orspeculative purposes.

 

You should be aware that many of the statements contained in thissection are forward looking and should be read in conjunction with ourdisclosures under the heading “Forward-Looking Statements.”

 

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**Item 4.  Controls and Procedures**

 

*ConclusionRegarding the Effectiveness of Disclosure Controls and Procedures*

 

Our chief executive officer and chief financial officer, with theassistance of management, evaluated the effectiveness of our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended) as of theend of the period covered by this report (the “Evaluation Date”). Based on thatevaluation, our chief executive officer and chief financial officer concludedthat, as of the Evaluation Date, our disclosure controls and procedures wereeffective to ensure that information required to be disclosed in our reportsunder the Exchange Act, is recorded, processed, summarized and reported within thetime periods specified in the SEC’s rules and forms, and that suchinformation is accumulated and communicated to management, including our chiefexecutive officer and chief financial officer, as appropriate to allow timelydecisions regarding required disclosure.

 

However, no matter how well a control system is conceived and operated,it can provide only reasonable, not absolute, assurance that the objectives ofthe control system are met. In addition, the design of a control system mustreflect the fact that there are resource constraints and the benefits ofcontrols must be considered relative to costs. Therefore, no cost-effectivecontrol system and no evaluation of controls can provide absolute assurancethat all control issues and instances of misstatements due to error or fraud,if any, within our company have been detected.

 

*Changesin Internal Controls*

 

Therehave been no changes in our internal control over financial reporting duringthe three months ended June 30, 2010 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

**PART II - OTHER INFORMATION**

 

**Item 1.  Legal Proceedings.**

 

SeeNotes 8 and 10 to the Consolidated Financial Statements above, and Item 1 -Business - Corporate Indemnification Matters and Item 3 - Legal Proceedings inour Annual Report on Form 10-K for the year ended December 31, 2009.

 

**Item 6.  Exhibits.**

 
| 31.1 |   | Section 302  Certificate of Raymond J. Pacini, Chief Executive Officer of California  Coastal Communities, Inc.                                                  |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Section 302  Certificate of Sandra G. Sciutto, Chief Financial Officer of California  Coastal Communities, Inc.                                                  |
| 32.1 |   | Section 906  Certificate of Raymond J. Pacini, Chief Executive Officer and Sandra G.  Sciutto, Chief Financial Officer of California Coastal  Communities, Inc.* |

 

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*              These certifications are beingfurnished solely to accompany this report pursuant to 18 U.S.C.Section 1350, and are not being filed for purposes of Section 18 ofthe Securities Exchange Act of 1934, as amended, and are not to be incorporatedby reference into any filing of the Company, whether made before or after thedate hereof, regardless of any general incorporation language in such filing.

 

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**SIGNATURE**

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.

 
| Date:  August 16, 2010 | CALIFORNIA  COASTAL COMMUNITIES, INC. |
|-----------------------------|---------------------------------------|
|                        |                                  |
|                        |                                  |
|                        | By:                                   | */s/  Sandra G. Sciutto* |
|                        |                                  | SANDRA  G. SCIUTTO |
|                        |                                  | Senior  Vice President and |
|                        |                                  | Chief  Financial Officer |

 

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