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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 March 31, 2010**

** **

**OR**

** **

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

** **

**For the transition period from                   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 checkmark whether the registrant has submitted electronically and posted on itscorporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 ofthis chapter) during the preceding 12 months (or for such shorter period thatthe registrant was required to submit and post such 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 May 13, 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 MARCH 31, 2010**

 

**INDEX**

 
| Cautionary Statement About Forward-Looking Statements |                    | 3                                                                                                    |
|-------------------------------------------------------|-------------------------|------------------------------------------------------------------------------------------------------|
|                                                  |                    |                                                                                                 |   |   |
| Part I -                                         | Financial  Information: |                                                                                                 | 5 |
|                                                  |                    |                                                                                                 |   |   |
|                                                  | Item 1.                 | Consolidated  Financial Statements                                                                   |   | 5 |
|                                                  |                    |                                                                                                 |   |   |
|                                                  |                    | Consolidated Balance Sheets - March 31, 2010  (unaudited) and December 31, 2009            |   | 5 |
|                                                  |                    |                                                                                                 |   |   |
|                                                  |                    | Consolidated Statements of Operations - Three Months  Ended March 31, 2010 and 2009 (unaudited) |   | 6 |
|                                                  |                    |                                                                                                 |   |   |
|                                                  |                    | Consolidated Statements of Cash Flows -Three Months  Ended March 31, 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                                          |   | 37 |
|                                                  |                    |                                                                                                 |   |   |
|                                                  | Item 4.                 | Controls and  Procedures                                                                             |   | 38 |
|                                                  |                    |                                                                                                 |   |   |
| Part II -                                        | Other Information:      |                                                                                                 | 38 |
|                                                  |                    |                                                                                                 |   |   |
|                                                  | Item  1.                | Legal  Proceedings                                                                                   |   | 38 |
|                                                  |                    |                                                                                                 |   |   |
|                                                  | Item 6.                 | Exhibits                                                                                             |   | 38 |
|                                                  |                    |                                                                                                 |   |   |
| SIGNATURE                                             |                    | 39                                                                                                   |

 

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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 and Section 21Eof the Securities Exchange Act of 1934 that relate to future events or ourfuture financial performance. In addition, other statements we may make fromtime to time, such as press releases, oral statements made by our officials andother reports that we file with the Securities and Exchange Commission may alsocontain such forward-looking statements. Undue reliance should not be placed onthese statements which involve known and unknown risks, uncertainties and otherfactors which may cause our actual results, performance or achievements to bematerially different from any future results, performances or achievementsexpressed or implied by the forward-looking statements. In some cases, you canidentify forward-looking statements by terminology such as “may,” “will,” “should,”“expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,”“continue,” or the negative of such terms or other comparable terminology.

 

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

 

·                  the impact, effect and eventual result of theChapter 11 Cases in restructuring our debt obligations under the Revolving Loanand Term Loan;

 

·                  our and the other Debtors’ability to remain as a debtors-in-possession during the pendency of the Chapter11 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;

 

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·                  the impact of recentaccounting pronouncements; and

 

·                  stock market valuations.

 

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; 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 Revolving and Term Loan agreements;the demand for homes; adverse market conditions that could result in additionalinventory impairments, including an oversupply of unsold homes, declining homeprices, and increased foreclosure and short sale activity; declines in consumerconfidence; increases in competition; fluctuations in interest rates and theavailability of mortgage financing; mortgage foreclosure rates; theavailability and cost of land for future growth; the availability of capital,including access under our existing credit facilities; uncertainties andfluctuations in capital and securities markets; changes in tax laws and theirinterpretation; legal proceedings; the ability of customers to finance thepurchase of homes or sell existing homes; the availability and cost of laborand materials; the amount of our debt and the impact of restrictive covenantsin our loan agreements; adverse weather conditions; domestic and internationalpolitical events; geopolitical risks and the uncertainties created by terroristattacks; the effects of governmental regulation, including regulationsconcerning development of land, the home building industry, sales and customerfinancing processes, and the environment; and other risks discussed in ourfilings with the Securities and Exchange Commission. Many factors mentioned inthis report or in other reports or public statements made by us, such asgovernment regulation and the competitive environment, will be important indetermining our future performance. Consequently, actual results may differmaterially from those that might be anticipated from our forward-lookingstatements. You should not place undue reliance on any of these forward-lookingstatements because they are based on current expectations or beliefs regardingfuture events or circumstances, 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 these forward-lookingstatements.

 

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 “Risk Factors” and thedescription of trends and other factors in “Management’s Discussion andAnalysis of Financial Condition and Results of Operations,” set forth in this Form 10-Qand in our Form 10-K for the year ended December 31, 2009. You shouldalso read the following “Consolidated Financial Statements” and the relatednotes.

 

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 this Form 10-Qor any other report filed by us. No such update shall be deemed to indicatethat other statements not addressed by such update remain correct or create anobligation to provide any other updates.

 

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**PART I - FINANCIAL INFORMATION**

 

**Item1.  Financial Statements.**

 

CALIFORNIA COASTAL COMMUNITIES, INC.

 

(DEBTOR-IN-POSSESSION)

 

CONSOLIDATED BALANCE SHEETS

 

(unaudited)

 

(in millions)

 
| ** **                                                                                                                                   | ** ** | **March 31,  2010** | ** ** | **December 31,  2009** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                   | ** ** | ** **               | ** ** | ** **                  | ** ** |
| ASSETS                                                                                                                                       | ** ** | ** **               | ** ** | ** **                  | ** ** |
| ** **                                                                                                                                   | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Cash and cash equivalents                                                                                                                    |       | $                        | 4.7        |                        | $          | 8.9 |   |
| Restricted cash                                                                                                                              |       | 0.8                      |       | 0.8                         |       |
| Real estate inventories                                                                                                                      |       | 239.2                    |       | 235.4                       |       |
| Other assets, net                                                                                                                            |       | 4.3                      |       | 4.8                         |       |
|                                                                                                                                         |       |                     |       |                        |       |
|                                                                                                                                         |       | $                        | 249.0      |                        | $          | 249.9 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                    | ** ** | ** **               | ** ** | ** **                  | ** ** |
| ** **                                                                                                                                   | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Liabilities not subject to compromise:                                                                                                       |       |                     |       |                        |       |
| Accounts payable and accrued liabilities                                                                                                     |       | $                        | 4.3        |                        | $          | 2.9 |   |
| Model home financing                                                                                                                         |       | 22.5                     |       | 22.5                        |       |
| Other liabilities                                                                                                                            |       | 0.4                      |       | 0.4                         |       |
|                                                                                                                                         |       |                     |       |                        |       |
| Total liabilities not subject to compromise                                                                                                  |       | 27.2                     |       | 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—$.05 par value; 13,500,000 shares  authorized; 10,995,902 and 10,995,902 shares issued and outstanding,  respectively |       | 0.5                      |       | 0.5                         |       |
| Excess Stock—$.05 par value; 13,500,000 shares  authorized; no shares outstanding                                                       |       | —                   |       | —                      |       |
| Additional paid-in capital                                                                                                                   |       | 59.5                     |       | 59.5                        |       |
| Accumulated deficit                                                                                                                          |       | (26.4                    | )          | (24.0                       | )          |
| Accumulated other comprehensive loss, net                                                                                                    |       | (2.6                     | )          | (2.6                        | )          |
| Total stockholders’ equity                                                                                                              |       | 31.0                     |       | 33.4                        |       |
|                                                                                                                                         |       |                     |       |                        |       |
|                                                                                                                                         |       | $                        | 249.0      |                        | $          | 249.9 |   |

 

See the accompanying notes to Consolidated Financial Statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

(DEBTOR-IN-POSSESSION)

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

(in millions, except per share amounts)

 

(unaudited)

 
| ** **                                    | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                    | ** ** | **2010**                                         | ** ** | **2009** | ** ** |
| ** **                                    | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Revenues:                                     |       |                                             |       |   |   |
| Homebuilding                                  |       | $                                                | 3.0        |   | $ | 12.8 |   |
|                                          |       |                                             |       |   |   |
| Costs of sales:                               |       |                                             |       |   |   |
| Homebuilding                                  |       | 2.6                                              |       | 8.8 |   |
| Loss on impairment of real estate inventories |       | —                                           |       | 3.2 |   |
|                                          |       | 2.6                                              |       | 12.0 |   |
|                                          |       |                                             |       |   |   |
| Gross operating profit                        |       | 0.4                                              |       | 0.8 |   |
|                                          |       |                                             |       |   |   |
| Selling, general and administrative expenses  |       | 1.4                                              |       | 1.5 |   |
| Reorganization costs                          |       | 1.3                                              |       | — |   |
| Interest expense                              |       | —                                           |       | 0.7 |   |
| Gain on debt restructuring                    |       | —                                           |       | (20.7 | ) |
| Other expense, net                            |       | 0.1                                              |       | 0.4 |   |
|                                          |       |                                             |       |   |   |
| (Loss) income before income taxes             |       | (2.4                                             | )          | 18.9 |   |
|                                          |       |                                             |       |   |   |
| Income tax expense                            |       | —                                           |       | 7.7 |   |
|                                          |       |                                             |       |   |   |
| Net (loss) income                             |       | $                                                | (2.4       | ) | $ | 11.2 |   |
|                                          |       |                                             |       |   |   |
| Net (loss) earnings per common share:         |       |                                             |       |   |   |
|                                          |       |                                             |       |   |   |
| Basic and diluted                             |       | $                                                | (0.22      | ) | $ | 1.02 |   |
|                                          |       |                                             |       |   |   |
| Common equivalent shares:                     |       |                                             |       |   |   |
|                                          |       |                                             |       |   |   |
| Basic and diluted                             |       | 11.0                                             |       | 11.0 |   |

 

See theaccompanying notes to Consolidated Financial Statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

(DEBTOR-IN-POSSESSION)

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

(in millions)

(unaudited)

 
| ** **                                                                       | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2010**                                         | ** ** | **2009** | ** ** |
|                                                                             |       |                                             |       |   |   |
| Cash flows from operating activities:                                            |       |                                             |       |   |   |
| Net (loss) income                                                                |       | $                                                | (2.4       | ) | $ | 11.2 |   |
| Adjustments to reconcile net loss to cash used in  operating activities:         |       |                                             |       |   |   |
| Gain on debt restructuring                                                       |       | —                                           |       | (20.7 | ) |
| Model homes depreciation                                                         |       | 0.1                                              |       | 0.1 |   |
| Deferred taxes                                                                   |       | (1.0                                             | )          | 7.7 |   |
| Deferred tax asset valuation allowance                                           |       | 1.0                                              |       | — |   |
| Gains on sales of real estate inventories                                        |       | (0.4                                             | )          | (4.0 | ) |
| Loss on impairment of real estate inventories                                    |       | —                                           |       | 3.2 |   |
| Proceeds from sale of real estate inventories, net                               |       | 2.8                                              |       | 12.5 |   |
| Investments in real estate inventories                                           |       | (5.8                                             | )          | (7.6 | ) |
| Non-cash reorganization items                                                    |       | 0.6                                              |       | — |   |
| Changes in assets and liabilities:                                               |       |                                             |       |   |   |
| Decrease in other assets                                                         |       | 0.1                                              |       | 1.2 |   |
| Increase in accounts payable, accrued and other  liabilities                     |       | 0.8                                              |       | 1.9 |   |
|                                                                             |       |                                             |       |   |   |
| Cash (used in) provided by operating activities                                  |       | (4.2                                             | )          | 5.5 |   |
|                                                                             |       |                                             |       |   |   |
| Cash flows from financing activities:                                            |       |                                             |       |   |   |
| Borrowings of revolving loan                                                     |       | —                                           |       | 13.2 |   |
| Repayments of revolving loan                                                     |       | —                                           |       | (10.1 | ) |
| Repayments of term loan                                                          |       | —                                           |       | (1.8 | ) |
| Repayments of other project debt                                                 |       | —                                           |       | (0.5 | ) |
| Deferred financing costs                                                         |       | —                                           |       | (0.2 | ) |
|                                                                             |       |                                             |       |   |   |
| Cash provided by financing activities                                            |       | —                                           |       | 0.6 |   |
|                                                                             |       |                                             |       |   |   |
| Net (decrease) increase in cash and cash  equivalents                            |       | (4.2                                             | )          | 6.1 |   |
|                                                                             |       |                                             |       |   |   |
| Cash and cash equivalents - beginning of period                                  |       | 8.9                                              |       | 2.3 |   |
|                                                                             |       |                                             |       |   |   |
| Cash and cash equivalents - end of period                                        |       | $                                                | 4.7        |   | $ | 8.4 |   |
|                                                                             |       |                                             |       |   |   |
| Supplemental disclosures of cash flow information:                               |       |                                             |       |   |   |
| Cash paid during the period for income taxes                                     |       | $                                                | —     |   | $ | 0.1 |   |
| Cash paid during the period for reorganization  items                            |       | 0.7                                              |       | — |   |
|                                                                             |       |                                             |       |   |   |
| Supplemental disclosures of non-cash investing and  financing activities:        |       |                                             |       |   |   |
| Amortization of deferred financing costs  capitalized in real estate inventories |       | $                                                | 0.5        |   | $ | 0.6 |   |
| 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 CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

 

**Note 1 -Basis of Presentation**

 

The accompanying Consolidated Financial Statementshave been prepared by California Coastal Communities, Inc. and itsconsolidated subsidiaries (the “Company”), without audit, pursuant to the rules andregulations of the Securities and Exchange Commission. Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with generally accepted accounting principles have been condensed oromitted pursuant to such rules and regulations. The Company believes thatthese unaudited Consolidated Financial Statements reflect all materialadjustments (consisting only of normal recurring adjustments) and disclosuresnecessary for the fair presentation of the results of operations and statementsof financial position when read in conjunction with the Consolidated FinancialStatements and Notes thereto included in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2009. Intercompany accounts andtransactions have been eliminated.

 

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 restructure its senior secured revolving creditagreement (“Revolving Loan”) and senior secured term loan agreement (“Term Loan”)debt through the Chapter 11 reorganization process described below in Note 2,there can be no assurance that the Company will be able to successfully executesuch plan. In the event that the Company is not successful in that regard,substantial doubt would exist as to its ability to continue as a going concern.The accompanying Consolidated Financial Statements have been prepared assumingthat the Company will continue as a going concern and contemplate therealization of assets and the satisfaction of liabilities in the normal courseof business. As a result of the Chapter 11 reorganization process describedbelow, the realization of assets and the satisfaction of liabilities aresubject to uncertainty. While operating as “debtors-in-possession” underChapter 11, the Debtors may sell or otherwise dispose of or liquidate assets orsettle liabilities, subject to the approval of the Bankruptcy Court or asotherwise permitted in the ordinary course of business, in amounts other thanthose reflected in the accompanying Consolidated Financial Statements. Further,a plan of reorganization could materially change the amounts andclassifications of assets and liabilities in the historical consolidatedfinancial statements. The accompanying Consolidated Financial Statements do notinclude any direct adjustments related to the recoverability and classificationof assets or the amounts and classification of liabilities or any otheradjustments that might be necessary should the Company be unable to continue asa going concern or as a consequence of the Chapter 11 Cases.

 

**Note 2 — Chapter 11 Proceedingsand Plans of Management**

 

On October 27, 2009,the Company and certain of its direct and indirect wholly-owned subsidiaries(collectively with the Company, the “Debtors”) filed voluntary petitions (the “Chapter11 Petitions”) for relief under chapter 11 of title 11 (“Chapter 11”) of theUnited States Code (the “Bankruptcy Code”) in the United States BankruptcyCourt for the Central District of California (the “Bankruptcy Court”). TheChapter 11 Petitions are being jointly administered under the caption *In re California Coastal Communities, Inc.*, Case No. 09-21712-TA(the “Chapter 11 Cases”). The Debtors continue to operate their businesses andmanage their properties as “debtors-in-possession” under the jurisdiction ofthe Bankruptcy Court and in accordance with the applicable provisions of theBankruptcy Code and orders of the Bankruptcy Court. The Debtors have obtainedthe Bankruptcy Court’s approval to, among other things, continue to paycritical vendors with lien rights, sell homes free and clear of all liens on aninterim basis, use cash collateral on an interim basis, honor homeownerwarranties, meet payroll obligations and provide employee benefits. There canbe no assurance that the Company and the other Debtors will be able tosuccessfully 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.

 

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The Company has 13 director indirect consolidated subsidiaries which are not guarantors of the $81.7 millionRevolving Loan or the$99.8 million Term Loan and are not Debtors in the Chapter 11 Cases. Thesesubsidiaries are former owners of businesses unrelated to the Company’s currentoperations and have no current material operations.

 

*Plansof Management*

 

On March 26, 2010,the Company filed a proposed disclosure statement and proposed joint plan ofreorganization with the Bankruptcy Court, neither of which has been approved bythe Bankruptcy Court. The proposed joint plan provides for the extension of theRevolving Loan and the Term Loan to enable the Company to complete constructionand sale of the homes at its Brightwater project. Throughout the Chapter 11reorganization process the Company has tried and will continue to try to workwith the various members of its lending syndicate to determine whether aconsensual restructuring of the Revolving Loan and the Term Loan can beaccomplished. However, a majority of the Company’s lenders are opposed to theplan as filed, and there can be no assurance that the Company and the otherDebtors will be able to successfully confirm, consummate and execute a plan ofreorganization with respect to the Chapter 11 Cases that is acceptable to theBankruptcy Court and the creditors and other parties in interest. A courthearing on the adequacy of the disclosure statement was held on May 12,2010. The Company expects the Court to enter an order approving the disclosurestatement containing certain revisions. The Court scheduled a valuation hearingfor July 15, 2010 and a plan confirmation hearing for July 28, 2010.

 

The Company and the otherDebtors continue to operate their business as debtors-in-possession. TheCompany has incurred and will continue to incur significant costs associatedwith the reorganization which are expected to significantly affect the Company’sresults of operations. During the three months ended March 31, 2010, theCompany incurred reorganization costs aggregating approximately $1.3 millionand has incurred total reorganization costs of $2.6 million through such date.

 

The Company hasmaintained business operations through the reorganization process. The Company’sliquidity and capital resources, however, are significantly affected by theChapter 11 Cases, which have resulted in various restrictions on itsactivities, limitations on financing and a need to obtain Bankruptcy Courtapproval for various matters. In particular, the Debtors are not permitted tomake any payments on pre-petition liabilities without prior Bankruptcy Courtapproval. However, the Debtors have been granted relief in order to continuewage and salary payments and other employment benefits to employees as well asother related pre-petition obligations; to continue to construct and sellhomes; and to pay certain pre-petition trade claims held by critical vendorswith lien rights. The Company’s authorization to continue to use cashcollateral and to sell homes free and clear of liens with the consent of thelending syndicate is currently scheduled to terminate on June 30, 2010.

 

Under the priorityschedule established by the Bankruptcy Code, certain post-petition andpre-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 the Company’s business or various creditors, or when the Company willemerge from these proceedings. Future results will depend upon the confirmationand successful implementation of a plan of reorganization. The continuation ofthe Chapter 11 Cases, particularly if a plan of reorganization is not timelyconfirmed, could further adversely affect the Company’s operations.

 

The Company depends on cash flows generated from operations andavailable borrowing capacity to fund its Brightwater development, and to meetits debt service and working capital requirements. However, the Company’sability to continue to generate sufficient cash flows has been and willcontinue to be adversely affected by continued difficulties in the homebuildingindustry, continued weakness in the California economy, and negative publicityand prospective homebuyer concerns related to the bankruptcy. While the Companygenerated 31 net sales orders in the first nine months of 2009, it generatedonly two net sales orders at Brightwater during the fourth quarter of 2009,which the Company believes reflects the negative impact of the Chapter 11Cases, as well as the seasonal slowdown in sales. Thus far in 2010, the pace ofsales has continued to be slow, with only six net sales generated through May 10,2010 compared with seven net sales during the comparable period of 2009.

 

Due to cash requirements for on-going home construction and scheduleddebt amortization, the Company’s ability to meet future loan repaymentrequirements will depend on the confirmation of a plan of reorganization by theBankruptcy Court. Based on Brightwater sales in 2009 and the first quarter of2010, the current pace of home sales is not expected to generate sufficientcash flow to meet the Company’s currently scheduled loan repayments for theRevolving Loan and Term Loan as described in greater detail in Notes 5 and6.

 

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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 modified or new financings can beobtained in order for the Company to meet its debt obligations. 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 secure replacement financing,if needed, and the terms of such financing if it is available. The current housingand mortgage markets also present significant uncertainty as to the Company’sability to achieve sufficient positive cash flow from operations required tosatisfy its debt obligations and meet financial covenant requirements. SeeNotes 5 and 6 for further discussion.

 

Whilethe Company is striving to restructure its Revolving Loan and Term Loan debtthrough the Chapter 11 Cases, unless the Company is successful in amending andextending the terms of the Revolving Loan and Term Loan agreements, the Companydoes not believe that its cash, cash equivalents and future real estate salesproceeds will be sufficient to meet its debt obligations or to meet 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 concern.The Consolidated Financial Statements herein do not include any adjustmentsthat might result from the outcome of this uncertainty.

 

*LiabilitiesSubject to Compromise*

 

Liabilities subject tocompromise refers to pre-petition obligations which may be impacted by theChapter 11 Cases. These amounts represent the Company’s current estimate ofknown or potential pre-petition obligations to be resolved in connection withthe Chapter 11 Cases. Differences between estimated liabilities and the claimsfiled or to be filed will be investigated and resolved in connection with theclaims resolution process. The Company continues to evaluate these liabilitiesthroughout the continuation of the Chapter 11 Cases and adjusts amounts asnecessary. Such adjustments may be material. Due to the expected number ofcreditors, the claims resolution process may take considerable time tocomplete. Accordingly, the ultimate number and amount of allowed claims is notpresently known.

 

*ReorganizationCosts*

 

Reorganization costsinclude legal and professional fees incurred in connection with the Chapter 11Cases. During the three months ended March 31, 2010, the Company incurred$1.3 million of reorganization costs and paid approximately $700,000 of suchcosts. The Company has incurred total reorganization costs of $2.6 million fromOctober 2009 through March 31, 2010.

 

*NasdaqDelisting*

 

TheCompany’s common stock is currently trading over-the-counter in the recentlycreated OTCQB marketplace under the trading symbol “CALCQ.” The trading of theCompany’s common stock in the over-the-counter market rather than on Nasdaq maynegatively impact the trading price and the levels of liquidity available toits stockholders. In addition, securities that trade over-the-counter are noteligible for margin loans and will make the Company’s common stock subject tothe provisions of Rule 15g-9 of the Securities Exchange Act of 1934, asamended, commonly referred to as the “penny stock rule.”

 

On October 28,2009, the Company received a letter from Nasdaq notifying it that it haddetermined to delist the Company’s common stock from trading as a result of thecommencement of the Chapter 11 Cases. The Company appealed the Nasdaq determination on December 3, 2009and, on December 29, 2009, the Nasdaq Hearings Panel granted the Company’srequest to remain listed, subject to certain conditions, including (1) providingperiodic updates as to the status of the Brightwater credit facilitiesrestructuring efforts; and (2) emerging from the Chapter 11 process nolater than April 26, 2010. On April 9, 2010, the Company received adelisting determination notice from the Nasdaq Hearings Panel informing theCompany that its common stock would be delisted from the Nasdaq Stock Market asa result of the Company’s inability to emerge from the Chapter 11 process bythe April 26 deadline. The Nasdaq Listings and Hearings Review Councilsubsequently denied the Company’s request to review the Nasdaq Hearings Panel’sdetermination and its common stock was delisted at the open of trading on April 27,2010 when it commenced trading in the OTCQB marketplace.

 

The Company has filed anapplication with Nasdaq seeking the relisting of its securities on The NasdaqStock Market following the Company’s 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.  While the Company presentlyplans to take all necessary steps to ensure its compliance with the applicablerequirements, there can be no assurance as to whether or when the Company’scommon stock will be relisted on Nasdaq.

 

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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 financial statements of jointventures in which the Company has a controlling or majority economic interest(and thus are controlled by the Company) are consolidated with the Company’sfinancial statements. The Company’s investments in unconsolidated jointventures are accounted for using the equity method when the Company does nothave voting or economic control of the venture operations, as further describedin Note 5 to the Consolidated Financial Statements included in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2009. Allsignificant intercompany accounts and transactions have been eliminated inconsolidation.

* *

*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.

* *

*Reinstatement of 5% Ownership Limitation*

 

On May 13, 2010, the Company reinstated a ban on acquisitions ofadditional shares of its common stock, under certain circumstances, in order topreserve the tax benefits of the Company’s $164 million of net operating loss (“NOL”)carryovers. See Note 9 for additional discussion.

 

*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 new or modified financings can beobtained, if needed. 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 raisingadditional capital. There can be no assurance that the Company will be successfulin any of these endeavors. The limited credit availability for small businessespresents uncertainty as to the ability of the Company to secure additionalfinancing, if needed, and the terms of such financing if it is available, andas to the ability of the Company to achieve positive cash flow from operationsrequired to satisfy its obligations. See Notes 5 and 6 below for furtherdiscussion.

 

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*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.

* *

*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 March 31, 2010 and 2009, the Companyrecorded inland project impairment charges totaling zero and $3.2 million,respectively. See Note 4 — Real Estate Inventories.

 

In accordance with ASC 360-10-35, in developing estimated future cashflows for impairment testing for its real estate inventories, the Company hasincorporated its own market assumptions including those regarding home prices,sales pace, sales and marketing costs, infrastructure and home-building costs,and financing costs regarding real estate inventories. The Company’sassumptions are based, in part, on general economic conditions, the currentstate of the homebuilding industry, expectations about the short- and long-termoutlook for the housing market, and competition from other homebuilders in theareas in which the Company builds and sells homes. These assumptions cansignificantly affect the Company’s estimates of future cash flows. For thosecommunities deemed to be impaired, the Company determines fair value based ondiscounted estimated future cash flows using estimated absorption rates foreach community.

 

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 on January 1,2008 and as it applies to non-financial assets and liabilities on January 1,2009. The carrying amounts of the Company’s financial instruments includingcash and cash equivalents, restricted cash, accounts payable and accruedliabilities, model home financing, and other liabilities approximate theirrespective fair values because of the relatively short period of time betweenorigination of the instruments and their expected realization. Due to theChapter 11 Cases and current default status of the Company’s Revolving Loan andTerm Loan, the carrying amounts of the debt may not approximate fair value asof March 31, 2010. Accordingly, the fair value of debt that is included inliabilities subject to compromise in the Company’s consolidated balance sheetscannot be reasonably determined as of March 31, 2010, as the timing andamounts to be paid are subject to confirmation by the Bankruptcy Court. TheCompany has been notified that purchase/sale transactions involving theRevolving Loan and Term Loan have occurred between certain members of the loansyndicates and other financial or investment institutions. However, it is notpracticable for the Company to determine the fair value of the Revolving Loanand Term Loan as the transactions are occurring in a private market.

 

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*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. 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. The Company evaluates on a quarterly basis, whether avaluation allowance should be established based on its determination of whetherit is “more likely than not” that some portion or all of the deferred taxassets will be realized. In the Company’s assessment, appropriate considerationis given to all positive and negative evidence related to the realization ofthe deferred tax assets. This assessment considers, among other matters, thenature, frequency and magnitude of current and cumulative income and losses,forecasts of future profitability, the duration of statutory carryback orcarryforward periods, the Company’s experience with operating loss and taxcredit carryforwards 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 months ended March 31, 2010 and 2009, the Companyrecorded valuation allowances on deferred tax assets totaling $1.0 million andzero, respectively. See Note 9—Income Taxes.

 

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 certaintyincreases regarding the Company’s projected results of operations and there isobjectively verifiable evidence to support the realization of a portion of itsdeferred tax assets, an adjustment to the Company’s valuation allowance may berecorded to reflect greater expected utilization.

* *

*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 ofMarch 31, 2010, real estate inventories aggregated 364 lots and homes,including 17 model homes, six standing inventory homes completed and unsold,three homes completed and in escrow, and nine homes under construction and inescrow. Real estate inventories at March 31, 2010 included$238.6 million recorded for 274 lots and homes under development and 17model homes held under a financing lease at the Brightwater community as wellas a five-acre project outside the Brightwater community, which are located ona mesa north of the Bolsa Chica wetlands in Huntington Beach, California. Theadditional recorded value in real estate inventories reflects the fair value of73 lots at the Company’s subsidiary’s inland project in Lancaster, California.The Company capitalizes carrying costs including interest and property taxes,as well as direct construction costs, to real estate inventories during thedevelopment 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 theCompany began delivering homes at The Cliffs and The Breakers neighborhoodsduring the third quarter of 2008.

 

The Company recorded impairment charges totaling zero and $3.2 millionduring the three months ended March 31, 2010 and 2009, respectively.

 

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

 

Capitalized interest is allocated to real estateinventories when incurred and charged to cost of sales when the relatedproperty is delivered. Changes in capitalized interest follow (in millions):

 
| ** **                                | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                | ** ** | **2010**                                         | ** ** | **2009** | ** ** |
| Capitalized interest, beginning of period |       | $                                                | 36.8       |   | $ | 37.3 |   |
| Interest incurred and capitalized         |       | 3.0                                              |       | 4.0 |   |
| Charged to cost of sales                  |       | (0.6                                             | )          | (1.4 | ) |
| Charged to gain on debt restructuring     |       | —                                           |       | (4.2 | ) |
| Capitalized interest, end of period       |       | $                                                | 39.2       |   | $ | 35.7 |   |

 

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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.

 

As of March 31, 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, resulting in an aggregate of$21.7 million of principal due and unpaid as of March 31, 2010. A majorstockholder of the Company currently holds approximately 16% of the RevolvingLoan.

 

Interest on the facility is calculated on the average outstanding dailybalance and is paid monthly. Interest incurred on the Revolving Loan for thethree months ended March 31, 2010 and 2009 was $900,000 and$1.2 million, respectively, at weighted-average interest rates of 3.50%and 3.80%, respectively. Following the Company’s $1.7 million principal paymentdefault, effective October 1, 2009, interest began to accrue at thedefault rate specified in the loan; however, under the terms of the BankruptcyCourt’s cash collateral order, the Company continued paying interest at thenon-default rate of 3.50% and was current on such interest payments as of March 31,2010.

 

As of March 31, 2010, the Company has delivered 82 homes atBrightwater since inception of the project, including the 17 model homesincluded in the sale-leaseback transaction completed on December 31, 2008and two homes (one Cliffs and one Breakers) delivered during the three monthsended March 31, 2010. Due to the Chapter 11 Cases, no principal paymentswere made on the 12 homes delivered during the fourth quarter of 2009 and thefirst quarter of 2010.

 

As of March 31, 2010 and December 31, 2009, approximately$300,000 and $500,000, respectively, of deferred loan fees and closingcosts related to the Revolving Loan are included in other assets and amortizedover the 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 a maximum ratio, regarding which the Company has beennotified it is in default:

 
| **Reporting Period**                                 | ** ** | **Maximum  Loan-to-Value  Ratio** | ** ** |
|------------------------------------------------------|------------|-----------------------------------|------------|
| September 30, 2009 through March 30,  2010 |       | 35                                | %          |
| March 31, 2010 and thereafter                   |       | 30                                | %          |

 

·                  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 March 31, 2010, the Company’s consolidated total liabilitiesare $218.0 million, tangible net worth after excluding the 2009 and 2008inland impairment charges and valuation allowances on deferred tax assets is$105.4 million and the leverage ratio is 2.07. The Company is incompliance with the leverage and net worth covenants. However, the Company wasnotified on September 28, 2009 that it is not in compliance with theloan-to-value ratio covenant of the Revolving Loan based on an appraisalobtained in August 2009 by the agent for the Revolving Loan and TermLoan.  In addition, the Company is not incompliance with the minimum sales covenant which requires that the sum of thecumulative number of homes delivered as of March 31, 2010 plus 50% of thenumber of homes in escrow at March 31, 2010 equal or exceed 96. As of March 31,2010, the Company had delivered 82 homes and had 12 homes in escrow for minimumsales of 88. Under the proposed Chapter 11 plan of reorganization, thesecovenants 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 does not expect to be able to fully re-pay theRevolving Loan by its current maturity date on June 30, 2010 from cashflow from operations.  The Company isstriving to restructure the Revolving Loan and Term Loan through the Chapter 11reorganization process to extend the maturity dates of the loans and defer scheduledamortization payments in order to accommodate the expected sales pace of theBrightwater project and provide sufficient liquidity to fund continued homeconstruction.  There can be no assurancethat the Company will be successful in any of these endeavors. While the nationalcredit markets appear to be improving, there is limited availability offinancing for small businesses, which presents significant uncertainty as tothe ability of the Company to secure additional financing, and the terms ofsuch financing if available. The current housing and jumbo mortgage marketsalso present uncertainty as to the ability of the Company to achieve sufficientpositive cash flow from operations required to satisfy its debt obligations.

** **

**Note 6 —Term Loan**

 

See Note 2 for detailed discussion of the status of the Chapter 11 Caseswhich commenced October 27, 2009.

 

As of March 31, 2010 and December 31, 2009,$99.8 million was outstanding for both periods under the Term Loan.  The Company did not pay $9.8 million due on December 31,2009 and $15.0 million due on March 31, 2010, resulting in an aggregate of$24.8 million of principal due and unpaid as of March 31, 2010.  A major stockholder of the Company currentlyholds approximately 19% of the Term Loan.

 

Interest on the facility is calculated on the average outstanding dailybalance and is paid monthly. Interest incurred on the Term Loan for the threemonths ended March 31, 2010 and 2009 was $1.3 million and$1.7 million, respectively, at weighted-average interest rates of 4.25%and 5.07%, respectively. Following the Company’s $1.7 million principal paymentdefault on the Revolving Loan, effective October 1, 2009, interest underthe 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 4.25% and wascurrent on such interest payments as of March 31, 2010.

 

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 million release priceper unit thereafter. As of September 30, 2009, the Company had delivered70 homes. These mandatory repayments are applicable to the commitmentreductions.  However, due to the Chapter11 Cases, no principal payments were made on the additional 12 homes deliveredduring the fourth quarter of 2009 and first quarter of 2010.

 

As of March 31, 2010, the Company has delivered 82 homes at Brightwatersince inception of the project, including the 17 model homes included in thesale-leaseback transaction completed on December 31, 2008 and two homes(one Cliffs and one Breakers) delivered during the three months ended March 31,2010, and made cumulative mandatory repayments for the Term Loan of$25.2 million.

 

As of March 31, 2010 and December 31, 2009, approximately$1.6 million and $1.9 million, respectively, of deferred loan fees andclosing costs related to the Term Loan are included in other assets andamortized over the life of the loan. Amortization of these costs is included inthe capitalization of interest allocated to real estate inventories, andcharged to cost 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:

 

·                  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.

 

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·                  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 consolidated tangiblenot worth covenant of $80 million, excluding impairment charges for inlandprojects and valuation allowances on deferred tax assets.

 

·                  A prohibition on dividends.

 

As of March 31, 2010, the Company’s consolidated total liabilitiesare $218.0 million, tangible net worth after excluding the 2009 and 2008inland impairment charges and valuation allowances on deferred tax assets is$105.4 million and the leverage ratio is 2.07. The Company is in compliancewith the aforementioned covenants except for the loan-to-value and interestcoverage covenants. The Company was notified on September 28, 2009 that itis not in compliance with the loan-to-value ratio covenant of the Term Loanbased on an August 2009 appraisal obtained by the agent for the RevolvingLoan and Term Loan.  In addition, theCompany is not in compliance with the minimum sales covenant which requiresthat the sum of the cumulative number of homes delivered as of March 31,2010 plus 50% of the number of homes in escrow at March 31, 2010 equal orexceed 96. As of March 31, 2010, the Company had delivered 82 homes andhad 12 homes in escrow for minimum sales of 88. Under the proposed Chapter 11plan of reorganization, 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, the Company did not make themandatory repayments due on December 31, 2009 or March 31, 2010.  The Company is striving to restructure theRevolving Loan and Term Loan through the Chapter 11 reorganization process toextend the maturity dates of the loans and defer scheduled amortizationpayments in order to accommodate the expected sales pace of the Brightwaterproject and provide sufficient liquidity to fund continued homeconstruction.  There can be no assurancethat the Company will be successful in any of these endeavors. While thenational credit markets appear to be improving, there is limited availabilityof financing for small business, which presents uncertainty as to the abilityof the Company to secure additional financing, and the terms of such financing,if available. The current housing and mortgage markets also present uncertaintyas to the ability of the Company to achieve sufficient positive cash flow fromoperations required to satisfy its debt obligations.

** **

**Note 7—Model Home 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 expiring December 31,2011, with two renewal options for one year each. As required by the leaseagreement, the Company prepaid six months of rent totaling $1.6 million onDecember 31, 2008. During the three months ended March 31, 2010, theCompany made model home lease payments totaling $788,000. 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 therelated lease agreement are as follows (in millions):

 
| **Year** | ** ** | **Amount** | ** ** |
|----------|------------|------------|------------|
| 2010     |       | $          | 2.4        |   |
| 2011     |       | 3.3        |       |
| Total    |       | $          | 5.7        |   |

 

**Note 8 - Other Liabilities (NotSubject to Compromise and Subject to Compromise)**

 

As of March 31, 2010and December 31, 2009, other liabilities not subject to compromiseincluded contingent indemnity and environmental obligations totaling $400,000.

 

As of March 31, 2010and December 31, 2009, other liabilities subject to compromise werecomprised of the following (in millions):

 
| ** **                                         | ** ** | **Subject to Compromise** | ** ** |
|----------------------------------------------------|------------|---------------------------|------------|
| ** **                                         | ** ** | **March 31,  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  March 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------------------|------------|
| ** **                           | ** ** | **2010**                                         | ** ** | **2009** | ** ** |
| Balance at beginning of period       |       | $                                                | 1.9        |   | $ | 1.7 |   |
| Provision                            |       | —                                           |       | — |   |
| Adjustment due to change in estimate |       | —                                           |       | — |   |
| Payments                             |       | —                                           |       | — |   |
| Balance at end of period             |       | $                                                | 1.9        |   | $ | 1.7 |   |

 

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**Note 9 - Income Taxes**

 

 

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

 
| ** **                                  | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                  | ** ** | **2010**                                         | ** ** | **2009** | ** ** |
| Current taxes                               |       | $                                                | —     |   | $ | — |   |
| Deferred taxes                              |       | 1.0                                              |       | 7.7 |   |
| Valuation allowances on deferred tax assets |       | (1.0                                             | )          | — |   |
| Income tax expense (benefit)                |       | $                                                | —     |   | $ | 7.7 |   |

 

During 2009 and the first quarter of 2010, theCompany recorded valuation allowances for the entire amount of its net deferredtax assets due to uncertainties regarding the resolution of the Chapter 11Cases filed October 27, 2009. The Chapter 11 filing constitutessignificant negative evidence under ASC 740-10 as it represents uncertaintiesrelated to future projected taxable income. At this time, the Company is unableto conclude 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 carrybacks of the applicable NOL. The Company expects to file a refund claimfor federal alternative minimum tax paid for years prior to 2009 andanticipates receiving the refund during 2010.

 

The federal NOLs available as of March 31, 2010 were approximately$164 million. The amount of federal NOLs which expire if not utilized is$49 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 the value of the Company’s equity before theownership change, multiplied by the long-term tax-exempt rate (4.03% as of May 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 existing as of the ownership change date. TheCompany estimates that after giving effect to various transactions bystockholders who hold a 5% or greater interest in the Company, it hasexperienced a three-year cumulative ownership shift of approximately 29% as of May 10,2010, as computed in accordance with Section 382. While the Company’s netdeferred tax assets are currently fully reserved due to the uncertainty of thetiming and amount of future taxable income, if the Company generates taxableincome in future periods, reversal of all or a portion of the valuation allowancecould have a significant positive impact on net income in the period that itbecomes more likely than not that the deferred tax assets will be utilized. Inthe event of an ownership change, the Company’s use of the NOLs may be limitedand not fully available for realization.

 

On May 13,2010, the Company reinstated a ban on acquisitions of additional shares of itscommon stock, under certain circumstances, in order to preserve the taxbenefits of the Company’s $164 million of NOLs. In accordance with provisions of the Company’s charter documents, unlessthe Company has previously consented in writing (i) no stockholder mayacquire shares in an amount that would cause the stockholder to own 5% or moreof the common stock; and (ii) no current 5% or greater stockholder mayacquire any additional shares of common stock.

 

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 necessitates 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.

 

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Allacquisitions of the Company’s common stock in violation of its charterprohibitions are null and void, and the Company is empowered to effectivelyreverse the effect of any such acquisitions. The Company’s Board of Directors may, but is not required to, entertainrequests for permission to exceed the limitations on stock acquisitions undercircumstances it determines are not likely to jeopardize the Company’s abilityto 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 milliondecrease in deferred tax assets for unrecognized tax benefits, which was offsetby an increase in deferred tax assets of $1.8 million for assetsre-evaluated as recognizable. The net change in deferred tax assets of$3.3 million was recorded as a cumulative effect of a change in accountingprinciple and resulted in a decrease to the January 1, 2007 retainedearnings balance of $200,000 and a decrease to the additional paid in capitalbalance of $3.1 million related to fresh-start accounting pursuant to a1997 pre-packaged bankruptcy.

 

Of the Company’s unrecognized tax benefits of $4.9 million at March 31,2010, $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 twelve months of the reporting date due tostatute of limitations lapses.

 

The Company recognizes interest expense and penalties related touncertain tax positions as interest or other expense. As of March 31,2010, the Company has not recorded any interest or penalties related tounrecognized tax 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 and the years 2005 through 2009 remain open for Federal andCalifornia purposes, respectively, for which the Company utilized NOLsgenerated between 1990 and 1993 to offset taxable income. If uncertaintiesresulting in valuation allowances can be favorably resolved, the Companyexpects to utilize Federal NOLs generated in 1995 through 1997 and in 1999,2006, 2007 and 2009 in future years. In addition, the Company would expect toutilize California NOL generated in 2007 and 2009 in future years.

 

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 andContingencies**

* *

*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 at various projects as of March 31,2010. At this time, the Company does not believe that a material amount of anycurrently outstanding performance or surety bonds will be called. The Companybelieves that all work required to be completed at this time under the bondingagreements has been completed and, therefore, draws upon these bonds, if any,will not have a material effect on the Company’s financial position, results ofoperations or cash flows.

* *

*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’s financialcondition or results of operations.

 

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*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 for December 2,2008, the District Court ruled that HRC can be held liable as a “current owner”of the site under applicable law. HRC applied to have that ruling certified forappeal. In March 2009, the District Court granted permission to hear HRC’sappeal and the appellate process commenced. Oral arguments are currentlyscheduled to be heard on June 9, 2010. HRC currently expects that it couldtake two to four months to complete the appellate process. There can be noassurance that HRC will receive a favorable ruling that it is not deemed to bea current owner of the site.  Once theappellate process is complete, the parties will return to the District Courtwithin 30 to 60 days to commence a trial.

* *

*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**

 

As of March 31, 2010,total stockholders’ equity is $31.0 million, reflecting beginning stockholders’equity of $33.4 million and net loss of $2.4 million during the three monthsended March 31, 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”). On April 28,1997, in connection with the Recapitalization, a new class of Common Stockreplaced the Series A Preferred Stock and Class A Common Stock, andthe Compensation Committee of the Board authorized the grant of stock optionsfor 759,984 shares, equivalent at that time to 6% of the Company’s fullydiluted equity, for certain directors and officers. At the May 2004 and June 2006stockholder meetings, the stockholders of the Company authorized an additional150,000 and 250,000 stock options, respectively, for the 1993 Plan, resultingin total authorized grants of 1,159,984.

 

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During the three months ended March 31, 2010 and 2009, the Companyissued a total of zero and 125,000 shares, respectively, of its common stock tothree independent directors under the Director Fee Program, which is acomponent of the 1993 Plan. The Company is currently prohibited from issuingshares due to its bankruptcy proceedings. The 2009 restricted shares vested ata rate of 25% per quarter during 2009.

 

The Company did not grant any options during the three months ended March 31,2010 and 2009. Pursuant to ASC 718-10, “*Compensation — StockCompensation*,” the Company recorded zero and $18,000 of compensationexpense during the three months ended March 31, 2010 and 2009,respectively, which is reflected in additional paid-in capital.

 

A summary of the status of the Company’s 1993 plan for the three monthsended March 31, 2010 follows:

 
| ** **                                    | ** ** | **Number of  Options** | ** ** | **Weighted-Average  Exercise  Price** | ** ** | **Weighted-Average  Remaining  Life** | ** ** |
|-----------------------------------------------|------------|-----------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| Outstanding, January 1                   |       | 17,500                      |       | $                                     | 21.58      | (a)                                   |       |   |
| Granted                                       |       | —                      |       | $                                     | —     |                                  |       |   |
| Exercised                                     |       | —                      |       | $                                     | —     |                                  |       |   |
| Outstanding, March 31                    |       | 17,500                      |       | $                                     | 21.58      | (a)                                   | 5.85 years |   |
|                                          |       |                        |       |                                  |       |                                  |       |
| Fully vested and exercisable at March 31 |       | 17,500                      |       | $                                     | 21.58      | (a)                                   | 5.85 years |   |
|                                          |       |                        |       |                                  |       |                                  |       |
| Available for future grants at March 31  |       | 221,794                     |       |                                  |       |                                  |       |

 

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(a)           Adjusted for specialdividend of $12.50

 

As of March 31, 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 5.85 years. All outstanding stockoptions are fully vested. The aggregate intrinsic value of all outstanding,fully-vested and exercisable stock options at March 31, 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 SFAS 123(R) and SAB 107. The risk-freeinterest rate used in the Option Model is based on the yield of U.S. Treasurieswith a maturity closest to 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 that involve risks anduncertainties as set forth in “Cautionary Statements About Forward-LookingStatements” at the beginning of this Quarterly Report on Form 10-Q. Actualresults may differ materially from those indicated in the forward-lookingstatements set forth below. Factors that may cause such a difference include,but are not limited to, those discussed in “Item 1A. Risk Factors” of ourAnnual Report on Form 10-K for the year ended December 31, 2009.

 

**Status of Chapter 11 Cases**

 

On October 27, 2009,California Coastal Communities, Inc. (“we”) and certain of our direct andindirect wholly-owned subsidiaries (collectively with us, 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 sole purpose of the Chapter11 Cases is to restructure the debt obligations under our senior securedrevolving credit agreement (“Revolving Loan”) and our senior secured term loan (“TermLoan”) for whichKeyBank National Association (“KeyBank”) originally served as the agent to thelending syndicates. On February 26, 2010, KeyBank notified us and thelenders of their resignation as agent. Effective April 6, 2010, WilmingtonTrust, FSB agreed to serve as agent for the syndicates. As of March 31,2010, $81.7 million in principal amount was outstanding on the Revolving Loanand $99.8 million in principal amount was outstanding on the Term Loan. A majorstockholder of the Company currently holds approximately 16% of the RevolvingLoan and 19% of the Term Loan.

 

We and the other Debtorscontinue to operate our businesses and manage our properties as “debtors-in-possession”under the jurisdiction of the Bankruptcy Court and in accordance with theapplicable provisions of the Bankruptcy Code and orders of the BankruptcyCourt. We 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.If the value of the Debtors’ assets and operations become materially impaired,our ability to continue as debtors-in-possession and to operate our business inthe present mode could be jeopardized. During the three months ended March 31,2010, we incurred costs totaling $1.3 million associated with thereorganization and have incurred total reorganization costs of $2.6 millionthrough such date. We will continue to incur significant costs associated withthe reorganization which are expected to adversely affect the results of ourbusiness operations.

 

On March 26, 2010,we filed a proposed disclosure statement and proposed joint plan ofreorganization with the Bankruptcy Court, neither of which has been approved bythe Bankruptcy Court. The proposed joint plan provides for the extension of theRevolving Loan and the Term Loan to enable us to complete construction and saleof the homes at our Brightwater project. Throughout the Chapter 11reorganization process we have tried to work with the various members of ourlending syndicate to determine whether a consensual restructuring of theRevolving Loan and the Term Loan can be accomplished. However, a majority ofour lenders are opposed to our plan and there can be no assurance that we andthe other Debtors will be able to successfully confirm, consummate and executea plan of reorganization with respect to the Chapter 11 Cases that isacceptable to the Bankruptcy Court and the creditors and other parties ininterest.  A court hearing on theadequacy of the disclosure statement was held on May 12, 2010. We expectthe Court to enter an order approving the disclosure statement containingcertain revisions. The Court has scheduled a valuation hearing for July 15,2010 and a plan confirmation hearing for July 28, 2010

 

We have maintainedbusiness operations through the reorganization process. Our liquidity andcapital resources, however, are significantly affected by the Chapter 11 Cases,which have resulted in various restrictions on our activities, limitations onfinancing and a need to obtain Bankruptcy Court approval for various matters.In particular, we and the other Debtors are not permitted to make any paymentson pre-petition liabilities without prior Bankruptcy Court approval. While theBankruptcy Court has consistently approved all of our requests to continue wageand salary payments and other employment benefits to employees, as well asother related pre-petition obligations, to continue to construct and sellhomes, and to pay certain pre-petition trade claims held by critical vendorswith lien rights; there can be no assurance that our future requests will beapproved. Our authorization to continue to use cash collateral and sell homesfree and clear of liens with the consent of our lending syndicate is currentlyscheduled to terminate on June 30, 2010.

 

Under the priorityschedule established by the Bankruptcy Code, certain post-petition andpre-petition liabilities need to be satisfied before general unsecured creditorsand equity holders are entitled to receive any distribution. At this time, itis not possible to predict with certainty the effect of the Chapter 11 Cases onour business or various creditors, or when we and the other Debtors will emergefrom these proceedings. Future results will depend upon the confirmation andsuccessful implementation of a plan of reorganization. The continuation of theChapter 11 Cases, particularly if a plan of reorganization is not timelyconfirmed, could further adversely affect our operations.

 

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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 bankruptcy. During the first three months of2010, we generated five net sales orders at Brightwater, which is equal to netsales 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.

 

Due to cash requirements for ongoing home construction and debtamortization, our ability to meet future loan repayment requirements willdepend on the results of the Chapter 11 Cases, as well as continued home salesat our Brightwater project.  Our goal isto restructure debt payments based on our current expectations for future salesover the next four years.  Theinventories of resale homes in the Huntington Beach coastal zip codes have beendeclining, which reduces the supply of resale homes with which Brightwater may compete.

 

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 modified financings can be obtained in order forus to meet our debt obligations. 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 securereplacement 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.

 

Whilewe are striving to restructure our debt through the Chapter 11 Cases, unless weare successful in amending and extending the terms of the Revolving Loan andTerm Loan agreements, we do not believe that our cash, cash equivalents andfuture real estate sales proceeds will be sufficient to meet our debtobligations as currently structured or to meet anticipated operating andproject development costs for Brightwater, and general and administrativeexpenses during the next 12 months. These factors raise substantial doubtabout our ability to continue as a going concern. Our Consolidated FinancialStatements set forth above do not include any adjustments that might resultfrom the outcome of this uncertainty.

* *

*NasdaqDelisting*

 

Ourcommon stock is currently trading over-the-counter in the recently createdOTCQB marketplace under the trading symbol “CALCQ.” The trading of our commonstock in the over-the-counter market rather than on Nasdaq may negativelyimpact the trading price and the levels of liquidity available to ourstockholders. In addition, securities that trade over-the-counter are noteligible for margin loans and will make our common stock subject to the provisionsof Rule 15g-9 of the Securities Exchange Act of 1934, as amended, commonlyreferred to as the “penny stock rule.”

 

On October 28,2009, we received a letter from Nasdaq notifying us that it had determined todelist our common stock from trading as a result of our commencement of theChapter 11 Cases.  We appealed the Nasdaqdetermination on December 3, 2009 and, on December 29, 2009, theNasdaq Hearings Panel granted our request to remain listed, subject to certainconditions, including (1) providing periodic updates as to the status ofthe Brightwater credit facilities restructuring efforts; and (2) emergingfrom the Chapter 11 process no later than April 26, 2010. On April 9,2010, we received a delisting determination notice from the Nasdaq HearingsPanel informing us that our common stock would be delisted from the NasdaqStock Market as a result of our inability to emerge from the Chapter 11 processby the April 26 deadline. The Nasdaq Listings and Hearings Review Councilsubsequently denied our request to review the Nasdaq Hearings Panel’sdetermination and our common stock was delisted at the open of trading on April 27,2010 when it commenced trading in the OTCQB marketplace.

 

We have filed anapplication with Nasdaq seeking the relisting of our securities on The NasdaqStock Market following our emergence from the Chapter 11 process.  In that regard, all companies, whether listedon Nasdaq or not, are required to satisfy the initial listing requirements uponemergence from a Chapter 11 process to qualify for listing.  While we presently plan to take all necessarysteps to ensure our compliance with the applicable requirements, there can beno assurance as to whether or when our common stock will be relisted on Nasdaq.

 

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**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;

 

·                  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 nine 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 nine months of 2010, our primary goals will be to:

 

·                  have our plan ofreorganization to restructure our obligations under the Term Loan and theRevolving Loan confirmed by the Bankruptcy Court as soon as possible, whichwould enable us to emerge from Chapter 11 bankruptcy during 2010; and

 

·                  continue constructing, sellingand 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 March 31, 2010 and2009 were $3.0 million and $12.8 million, respectively. For the threemonths ended March 31, 2010 and 2009, we delivered two and seven homes,respectively. Our total assets as of March 31, 2010 and December 31,2009 were $249.0 million and $249.9 million, respectively, with Brightwater andother nearby properties constituting $238.6 million (96% of total assets) and$234.8 million (94% of total assets), respectively. Our homebuildingsubsidiary, Hearthside Homes, Inc., has delivered over 2,300 homes tofamilies throughout Southern 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 our stockholdersin September 2006. As of March 31, 2010, we had $204.0 millionof debt against $31.0 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 on Form 8-K,and amendments to these reports filed or furnished pursuant to Section 13(d) or15(d) of the Securities Exchange Act of 1934 as soon as reasonablypracticable after they are filed with, or furnished to, the Securities andExchange Commission. Copies of our annual report on Form 10-K, quarterlyreports on Form 10-Q, current reports on Form 8-K, and amendments tothese reports are available free of charge upon request. In addition, at ourwebsite: http://www.californiacoastalcommunities.com, we post copies of ourSecurities and Exchange Commission filings and press releases, as well ascurrent versions of our code of ethics, audit committee charter and nominatingcommittee charter.

 

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**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 first quarter of 2010.Specifically, the credit markets and the mortgage industry experienced a periodof unparalleled turmoil and disruption characterized by bankruptcy, financialinstitution failure, consolidation and an unprecedented level of interventionby the United States federal government. This disruption on the credit marketshas made it more difficult for homebuyers to obtain acceptable financing,particularly for jumbo-mortgages. In addition, the supply of new and resale homesin the marketplace remained excessive for the levels of consumer demand,particularly given the supply of foreclosed homes offered at 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 quarter of 2010. While there have been signs of improvement in theeconomy and financial markets during the first quarter of 2010, weakness in thehomebuilding environment continued as unemployment remains at very high rates,and is expected to continue throughout the year.

 

Concern about the state of the economy and the job market continues tonegatively affect consumer confidence, as unemployment rates continued to risethroughout 2009 in almost all of the metropolitan areas tracked by the U.S.Department of Labor. The unemployment rate in California was 13.0% at the endof the first quarter of 2010 compared with 11.2% at the end of the firstquarter of 2009, while the unemployment rate in Orange County was 10.1% in March 2010compared with 8.5% in March 2009. These adverse conditions have nowpersisted to varying degrees since the beginning of 2006 and their impact isreflected in our results for the first quarters of 2010 and 2009.  We believe that the weak demand we areexperiencing, particularly for homes over $1.5 million, reflects the excesssupply of higher end homes in the Huntington Beach market as well as homebuyers’reluctance to make a purchasing decision until they are comfortable that homeprice declines are near bottom, that economic conditions have stabilized andthat our company will successfully emerge from Chapter 11. However, theinventories of resale homes in the Huntington Beach coastal zip codes have beendeclining, which reduces the supply of resale homes with which Brightwater maycompete, and the jumbo-mortgage market is showing signs of gradual improvement.There can be no assurance 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) appears to have boosted demand somewhat; however, thefederal stimulus plan has not had much impact on sales at our Brightwaterproject due to its income 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, an additional $200 million of funding was approved by the State ofCalifornia which will provide up to a $10,000 credit to first-time homebuyersor those purchasing a newly built home starting May 1, 2010.

 

While we have begun to see some positive signs that these negativetrends in the overall economy are moderating, such as rising stock markets andfewer new unemployment claims, it remains uncertain when the housing market orthe broader economy will experience a meaningful recovery. We anticipate thatthe overhang of bank-owned homes will continue to bloat the market throughout2010 as lenders seek to unload their inventory of foreclosed homes. We believethe current conditions may improve during 2010; however there can be noassurance in that regard.  In addition,we expect that market conditions will remain challenging and we expect that ouroperations may sustain periodic losses until the homebuilding industry andeconomy, as a whole, demonstrate a sustained rebound. Further, until we areable to restructure our Revolving Loan and Term Loan debt through the Chapter11 Cases, prospective buyers may be reluctant to purchase a home and we maycontinue to experience 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 April 2010,the spread has narrowed to approximately .50% to .80%. Mortgage marketliquidity issues and more stringent underwriting criteria have impeded some ofour home buyers from closing escrow, while others have found it more difficultto sell their 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 three months of 2010 we:

 

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

 

·                  filed a proposed disclosurestatement and proposed joint plan of reorganization for relief under Chapter 11in the Bankruptcy Court in order to restructure approximately $182 million ofindebtedness related to our Brightwater project.

 

We expect to continue operations at only the four Brightwatercommunities until we see reasonable signs of a housing market recovery.  If market conditions decline further, we mayneed to take additional charges for inventory impairments in futurequarters.  In addition, we expect thatour results for 2010 will be adversely affected by the costs of restructuringour debt through the Chapter 11 Cases. Our results could also be adversely affected if general economicconditions do not improve further or deteriorate, if consumer confidenceremains weak or declines further, if job losses continue or accelerate, ifforeclosures or distressed sales increase, or if consumer mortgage lendingbecomes less available or more expensive, any or all of which would furtherdiminish 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 three months of 2010 and 2009, we delivered two andseven homes, respectively. As of May 10, 2010, six additional homes havebeen delivered, bringing year-to-date deliveries to eight homes, and sevenadditional homes are in escrow, as discussed further under Item 1—Business--OurCurrent 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, that impact appears less severe than the weakness we haveseen in our inland markets. We believe that the reduced impact is a result ofBrightwater’s superior coastal location, the extremely limited supply of newhomes on the coast of Southern California and the absence of significantcompetition from other homebuilders in the Huntington Beach market due to thelack of available land for the development of new single family detached homes.We believe that Brightwater is in a location that is difficult to replace andin a market where approvals are increasingly difficult to achieve. We alsobelieve that Brightwater has substantial embedded value that should not besacrificed under current depressed market conditions but, rather, should berealized over time. Finally, we believe that Brightwater’s demographics remainstrong due to the continuing regulation-induced constraints on lot supplies andthe significant number of affluent households along the coast of SouthernCalifornia. Therefore, we remain optimistic about continuing sales atBrightwater.

 

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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. We believe the deceleration in sales pace for the fourthquarter of 2009 primarily reflects the negative impact of the Chapter 11announcement in October 2009. Our pace of sales since December 31,2009 remained slow, with only five net sales generated through March 31,2010. We anticipate that sales pace will continue to be negatively impacteduntil we successfully 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 experienceand on 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 two homes (one Cliffs and one Breakers) during the three months endedMarch 31, 2010, compared with seven deliveries (one Sands, one Cliffs,three Breakers and two inland projects homes) during the comparable period in2009. We acquired no single-family residential lots during the three monthsended March 31, 2010 and 2009 and we have no contracts to acquire land orlots.

 

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The following chart describes our current projects, their location andour lot and standing home inventories as of March 31, 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                     |       | 5           |       | 1                       |       | 3                             |       | 20                  |       | 33                        |       |
| The  Sands                         |       | Huntington Beach |       | 2007                       |       | 4                     |       | 1           |       | 2                       |       | 3                             |       | 53                  |       | 63                        |       |
| The  Cliffs                        |       | Huntington Beach |       | 2008                       |       | 4                     |       | 5           |       | 1                       |       | —                        |       | 89                  |       | 99                        |       |
| The  Breakers                      |       | Huntington Beach |       | 2008                       |       | 5                     |       | 1           |       | 2                       |       | 1                             |       | 87                  |       | 96                        |       |
| *Subtotal—Orange County*      |       |             |       |                       |       | 17                    |       | 12          |       | 6                       |       | 7                             |       | 249                 |       | 291                       |       |
| Lancaster:                         |       |             |       |                       |       |                  |       |        |       |                    |       |                          |       |                |       |                      |       |
| Unimproved  lots                   |       | Lancaster        |       | (c)                        |       | —                |       | —      |       | —                  |       | —                        |       | 73                  |       | 73                        |       |
| *Total—All Projects*          |       |             |       |                       |       | 17                    |       | 12          |       | 6                       |       | 7                             |       | 322                 |       | 364                       |       |

 

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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;however, the transaction is accounted for as a financing and therefore thosehomes are included in our home inventories.

(c)          To be determined subject tomarket conditions.

 

As of March 31, 2010, we had standing inventory of six Brightwaterhomes. During the three months ended March 31, 2010, net new ordersdecreased to five homes compared with seven homes during the comparable periodin 2009 due to the absence of sales activity at our inland projects comparedwith the first quarter 2009. Cancellations as a percentage of new orders were38% during the three months ended March 31, 2010, compared withapproximately 30% during the comparable period in 2009. Backlog as of March 31,2010 increased to 12 homes compared with eight homes as of March 31, 2009,reflecting five more Brightwater homes in escrow as of March 31, 2010,including four more of the larger Cliffs and Breakers homes.

 

*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, approximately35 miles south of downtown Los Angeles. Brightwater was annexed into the Cityof Huntington Beach in 2008. Brightwater offers a broad mix of home choicesaveraging 2,860 square feet and ranging in size from 1,710 square feet to 4,339square feet. Located near Pacific Coast Highway and overlooking the PacificOcean, Huntington Harbor and the restored 1,300-acre Bolsa Chica Wetlands, 63of the 356 homes at Brightwater will have unobstructed ocean and/or wetlandsviews.

 

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 of March 31,2010. This project is located on one of the last large undeveloped coastalproperties in Southern California. Brightwater is bordered on the north andeast by residential development in the City of Huntington Beach and HuntingtonHarbor, to the south by open space and the 1,300-acre Bolsa Chica wetlands, andto the west by 120 acres of publicly-owned conservation land and open space onthe lower bench of the Bolsa Chica mesa, Pacific Coast Highway, Bolsa ChicaState Beach, and the Pacific Ocean. Brightwater also has 37 acres of open spaceand 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. During January 2008,we completed construction of nine additional model homes for The Cliffs and TheBreakers and in February 2008 began selling homes to buyers who previouslyregistered on our priority list. We held a grand opening for theseneighborhoods 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 March 31,2010, we have delivered an aggregate of 65 homes (excluding the 17 model homes)at Brightwater, including 29, 16, 10, 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.

 

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·                  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.

 

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

 

·                  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 March 31,2010, approximately 76% 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 5% to 22% due to our low carryingvalue in Brightwater. Gross margins for the larger homes at The Cliffs and TheBreakers are currently expected to approximate 12% to 22%, while gross marginsat The Trails and The Sands are currently expected to approximate 5% to 14%.The decrease in expected margins reflects expected increases in interest ratesin connection with restructuring our debt, price reductions required to be competitiveunder current market conditions, additional incentives to sell standinginventory and greater use 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 and marketingplans. 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 months ended March 31, 2010 and 2009 wereas follows:

 
| ** **              | ** ** | ** **        | ** ** | **Deliveries**     | ** ** |
|-------------------------|------------|-------------------|------------|--------------------|------------|
| ** **              | ** ** | ** **        | ** ** | **March 31,** | ** ** |
| ** **              | ** ** | **Location**      | ** ** | **2010**           | ** ** | **2009** | ** ** |
| ** **              | ** ** | ** **        | ** ** | ** **         | ** ** | ** ** | ** ** |
| Brightwater             |       |              |       |               |       |   |   |
| The Sands               |       | Huntington  Beach |       | —             |       | 1 |   |
| The Cliffs              |       | Huntington  Beach |       | 1                  |       | 1 |   |
| The Breakers            |       | Huntington  Beach |       | 1                  |       | 3 |   |
|                    |       |              |       |               |       |   |   |
| * *                |       |              |       | 2                  |       | 5 |   |
| * *                |       |              |       |               |       |   |   |
| Inland Empire/Lancaster |       |              |       |               |       |   |   |
| Completed Projects      |       | Various           |       | —             |       | 2 |   |
| * *                |       |              |       |               |       |   |   |
| * *                |       |              |       | 2                  |       | 7 |   |

 

*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 in August 2007.We completed construction of nine model homes for The Cliffs and The Breakersin January 2008 and began selling homes in February 2008. Wedelivered 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 three months ended March 31,2010, we delivered two homes at an average price of $1.5 million, orapproximately $430 per square foot. As of May 10, 2010, seven Brightwaterhomes (including two homes with wetland and ocean views) are in escrow at anaverage price of $1.5 million, or approximately $542 per square foot, and 15additional homes are completed or under construction and have been released forsale.

 

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*The Trails and The Sands*

 

We did not deliver any homes at The Trails and The Sands during thethree months ended March 31, 2010. During the comparable period of 2009 wedelivered one Sands home and generated $1.1 million in revenue and grossoperating margins of 26.4%. We delivered an additional four Trails homes duringMay 2010 at an average price of $853,000. Homes at The Trails and TheSands are presently being offered at prices ranging from $810,000 to $1.0million. As of May 10, 2010, three homes are in escrow at The Trails andThe Sands, six homes are completed and unsold, and five homes are underconstruction and unsold.

 

*The Cliffs and The Breakers*

 

We delivered two and four homes at The Cliffs and The Breakers duringthe three months ended March 31, 2010 and 2009, respectively, and generatedrevenue of $3.0 million and $11.1 million, respectively, and gross operatingmargins of 12.1% and 33.0%, respectively. Three of the four homes deliveredduring the first quarter 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 two homes delivered during the first quarter of 2010, expected increases ininterest rates in connection with restructuring our debt, price reductionsrequired to be competitive under current market conditions, and greater use ofthird-party real estate brokers. We delivered an additional two Cliffs homesduring April and May 2010 at an average price of $1.3 million. Homesat The Cliffs and The Breakers are presently being offered at prices rangingfrom $1.3 million to $3.2 million for 2,724 to 4,339 square foot homes. Asof May 10, 2010, four homes are in escrow at The Cliffs and The Breakers,three homes are completed and unsold, and one home is under construction andunsold.

 

*The Ridge*

 

We are pursuing entitlement for 22 homes averaging 3,500 square feet inthe City of Huntington Beach near our existing Brightwater project. Entitlementof these lots is subject to approval by the City of Huntington Beach and theCalifornia Coastal Commission, and is currently expected to take two to threeyears.  On April 27, 2010 the Cityof Huntington Beach Planning Commission approved The Ridge project and it iscurrently expected to be presented to the City Council for their approval in July 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.

 

**Critical Accounting Policies andEstimates**

 

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.The financial statements of joint ventures in which we generally have acontrolling or majority economic interest (and thus are controlled by us) areconsolidated 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.

 

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*Impairment of Long-Lived Assets*

 

We recorded inland project impairment charges totaling zero and $3.2million during the three months ended March 31, 2010 and 2009,respectively.

 

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 accordance with ASC 360-10-35, in developing estimated future cashflows for impairment testing for our real estate inventories, we incorporatedour own market assumptions including those regarding home prices, sales pace,sales and marketing costs, infrastructure and home-building costs, andfinancing costs regarding real estate inventories. Our assumptions are based,in part, on general economic conditions, the current state of the homebuildingindustry, expectations about the short- and long-term outlook for the housingmarket, and competition from other homebuilders in the areas in which we buildand sell homes. These assumptions can significantly affect our estimates offuture cash flows. As required by ASC 360-10-35, should market conditionsdeteriorate in the future or other events occur that indicate the carryingamount of our real estate inventories may not be recoverable, we willreevaluate the expected cash flows from each project to determine whether anyadditional impairment exists at any point in time. For those communities deemedto be impaired, we determine fair value based on discounted estimated futurecash flows using estimated absorption rates for each community.

 

We evaluated our Brightwater project for impairment as of December 31,2009, and determined that no impairment was indicated based on our projectionof the project’s future cash flows, including projected revenues, costs andgross margin.  We based our assumptionson our evaluation of projected prices while reflecting current marketingefforts, review of competitive home sales, characteristics of the HuntingtonBeach housing market, and current construction costs.  Our relatively lower book basis inBrightwater of $233.5 million as of March 31, 2010, is due in part to afair value adjustment recorded in September 1997 under “Fresh Start”accounting.  Since 1997, we have recordedno impairment charges for Brightwater, primarily due to the long holding periodand significant increases in home prices since 1997, before the currentchallenging conditions 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 in August 2007,we have reduced prices and offered sales incentives in response to the recentdifficult conditions in the housing market. We have reflected these pricereductions in our projections which reduced average future projected grossmargins for the project from approximately 30%-40% in 2007 to 6%-33% as of December 2009and 5%-22% as of March 2010.  Thedecrease in expected margins also reflects greater expected use of third-partyreal estate brokers, particularly in the near-term, and expected increases ininterest rates in connection 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 months compared with seven to eight months in neighboringcoastal cities. Notably, since August 2009, supply at the $1.0 million to$1.5 million level has declined from nine months to five months as of May 2010.During the same time period, supply has declined from 21 months to 16 months atthe $2.0 million and above level. In January 2009, the City of 

 

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HuntingtonBeach’s credit rating was raised, reflecting the city’s built-out nature andexpected economic resilience of the city’s households.  Huntington Beach is in coastal Orange Countywhich is the subject of two widely respected annual economic forecasts which expectan increase in median home prices in 2010 and an increase in demand due toimproved 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.

 

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% in October 2008to approximately 5.75% currently and lenders are beginning to relax downpayment requirements which were as high as 30% for jumbo loans in the Fall of2009.  With the conforming loan maximumin Orange County continuing at $729,750, a significant portion of our potentialhomebuyers are able to finance a substantial portion of their home purchase athistorically low mortgage rates approximating 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. A 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. 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 theBankruptcy Court. Due to uncertainties regarding the resolution of our Chapter11 Cases and our ability to utilize our NOLs in the future, during 2009 werecorded a valuation allowance for the remaining amount of our net deferred taxassets. We recorded an additional valuation allowance of $1.0 million duringthe first quarter of 2010 related to deferred tax assets generated during thequarter.

 

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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. Our assumptionsrequire significant judgment because the residential homebuilding industry iscyclical and is highly sensitive to changes in economic conditions. Our currentassessment of the need for a valuation allowance is primarily dependent uponutilization of tax net operating losses in the carryforward period and ourfuture projected income. If our results of operations are more or less thanprojected and there is objectively verifiable evidence to support therealization of a different amount of our deferred tax assets, an adjustment toour valuation allowance may be required to reflect greater expectedutilization.

 

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 (4.03% as of May 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 existing as of the ownership change date. Weestimate that after giving effect to various transactions by stockholders whohold a 5% or greater interest in the company, we have experienced a three-yearcumulative ownership shift of approximately 29% as of May 10, 2010, ascomputed in accordance with Section 382. In the event of an ownershipchange, our use of our NOLs may be limited.

 

On May 13,2010, we reinstated a ban on acquisitions of additional shares of our CommonStock, under certain circumstances, in order to preserve the tax benefits ofour $164 million of NOLs.  In accordancewith provisions of our charter documents, unless we have previously consentedin writing (i) no stockholder may acquire shares in an amount that wouldcause the stockholder to own 5% or more of the common stock; and (ii) nocurrent 5% or greater stockholder may acquire any additional shares of commonstock.

 

Allacquisitions of our common stock in violation of our charter prohibitions arenull and void, and we are empowered to effectively reverse the effect of anysuch acquisitions.  Our Board ofDirectors may, but is not required to, entertain requests for permission toexceed the limitations on stock acquisitions under circumstances it determinesare not likely to jeopardize our ability to preserve and use our NOLs.

 

*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 havereserved for costs expected to be incurred with respect to these cases basedupon information provided by our legal counsel. There can be no assurance thattotal litigation costs actually incurred will not exceed the amount of suchreserve.

 

**Recent Accounting Pronouncements**

 

See discussion regardingNew Accounting Pronouncements in Note 3 to the Consolidated FinancialStatements.

 

**Results of Operations**

 

After filing theChapter 11 Cases, we are required to periodically file various documentswith, and provide certain information to the Bankruptcy Court, includingstatements of financial affairs, schedules of assets and liabilities, andmonthly operating reports in forms prescribed by Chapter 11, as well as certainfinancial information on an unconsolidated basis. Such materials will beprepared according to requirements of Chapter 11. While we believe that thesedocuments and reports provide then-current information required under Chapter11, they are prepared only for the Debtors and, therefore, certain

 

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operational entities are excluded. In addition, theyare prepared in a format different from that used in our Consolidated FinancialStatements filed under the securities laws and they are unaudited. Accordingly,we believe that the substance and format do not allow meaningful comparisonwith our regular publicly-disclosed Consolidated Financial Statements.Moreover, the materials filed with the Bankruptcy Court are not prepared forthe purpose of providing a basis for an investment decision relating to oursecurities, or for comparison with other financial information filed with theSEC.

 

The following tables setforth key operating and financial data for our homebuilding operations for thethree months ended March 31, 2010 and 2009.

 

**Backlogas of March 31**

 
| **Homes in Backlog** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|--------------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2010**                       | ** ** | **2009**                                 | ** ** | **Change**                                                      | ** ** | **2010** | ** ** | **2009** | ** ** | **Change** | ** ** | **2010** | ** ** | **2009** | ** ** | **Change** | ** ** |
| 12                             |       | 8                                        |       | 50.0                                                            | %          | $ | 15.8 |   | $ | 9.1 |   | 73.6 | % | $ | 1,319 |   | $ | 1,134 |   | 16.3 | % |
|                                |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**HomesDelivered****Three Months Ended March 31**

 
| **Homes Delivered** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|--------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2010**                 | ** ** | **2009**                                 | ** ** | **Change**                                                      | ** ** | **2010** | ** ** | **2009** | ** ** | **Change** | ** ** | **2010** | ** ** | **2009** | ** ** | **Change** | ** ** |
| 2                        |       | 7                                        |       | (71.4                                                           | )%         | $ | 3.0 |   | $ | 12.8 |   | (76.6 | )% | $ | 1,500 |   | $ | 1,829 |   | (18.0 | )% |
|                          |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Three Months Ended March 31, 2010 Comparedwith the Three Months Ended March 31, 2009*

 

We reported revenues of $3.0 million and gross operating profit of$400,000 for the first quarter of 2010, compared with $12.8 million inrevenues and gross operating profit of $800,000 for the first quarter of 2009.Revenues in the current period reflect deliveries of two Brightwater homes. Thecomparable period of the prior year reflects deliveries of seven homes,including five homes at Brightwater and two inland homes. Gross operatingprofit for the first quarter of 2009 includes a non-cash impairment charge of$3.2 million, reflecting a fair value write-down for an inland project inBeaumont which was disposed on September 30, 2009.

 

We generated $3.6 million less in gross operating profit beforeimpairment charges from home sales as a result of delivering only two homes atBrightwater which generated a 12.1% gross margin, compared with fiveBrightwater deliveries which generated a 32.2% gross margin during thecomparable period in 2009. The decrease in gross margin reflects the fact thatthree of the five Brightwater homes delivered during the first quarter of 2009included view premiums, compared with none in the first quarter of 2010. Inaddition, the decrease in gross margin during the first quarter of 2010reflects expected increases in interest rates in connection with restructuringour debt as well as sales price reductions offered in response to thecontinuing difficult conditions in the housing market and greater use ofthird-party brokers.

 

Reorganization costs of $1.3 million during the first quarter of 2010reflect legal and professional fees and other costs associated with the Chapter11 bankruptcy proceedings.

 

The $700,000 decrease in interest expense compared with the firstquarter of 2009 primarily reflects the absence of various inland projects whichwere sold or disposed in 2009 for which we are no longer incurring periodcosts.

 

*Payments Under ContractualObligations*

 

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 in Part II— Item 1 — Legal Proceedings, and in Note 10 to our ConsolidatedFinancial Statements above.

 

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**Liquidity and Capital Resources**

 

On September 28,2009, we received a notice of an event of default from the agent to the lendingsyndicate with respect to the loan-to-value covenant of the Revolving Loan that would give rise to the right toaccelerate the indebtedness under the Revolving Loan and Term Loan. In addition, on October 1, 2009,we received 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 March 31,2010, $81.7 million and $99.8 million of principal was outstanding under theRevolving Loan and Term Loan, respectively.

 

The filing of the Chapter11 Petitions on October 27, 2009, also constituted events of default underthe Revolving Loan and the Term Loan that can trigger acceleration of theindebtedness.  However, the filing of theChapter 11 Petitions automatically stayed those actions against us and theother Debtors.  Under the terms ofBankruptcy Court orders, we have continued to pay interest on the outstandingprincipal balance at pre-default interest rates.

 

While we are striving to restructure our debt through the Chapter 11Cases, unless we are successful in 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 be sufficient to meetour debt obligations or to meet anticipated operating and project developmentcosts for Brightwater, and general and administrative expenses during the next12 months. These factors raise substantial doubt about our ability tocontinue as a going concern. The Consolidated Financial Statements herein donot include any adjustments that might result from the outcome of thisuncertainty.

 

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

 
| ** **                                      | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|
| ** **                                      | ** ** | **March 31,**               | ** ** |
| ** **                                      | ** ** | **2010**                         | ** ** | **2009** | ** ** |
| Cash and cash equivalents                       |       | $                                | 4.7        |   | $ | 8.4 |   |
| Cash (used in) provided by operating activities |       | (4.2                             | )          | 5.5 |   |
| Cash provided by financing activities           |       | —                           |       | 0.6 |   |
|                                                 |            |                                  |            |  |  |  |  |

 

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 March 31, 2010aggregated $4.7 million, the use of which is subject to the BankruptcyCourt’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 approval ofour plan of reorganization to change principal payment schedules and to extendmaturities.

 

*March 31, 2010 Compared withDecember 31, 2009*

 

Cash used in operating activities of $4.2 million for the firstquarter of 2010 primarily reflects investments in Brightwater of$5.8 million, general and administrative costs of $1.4 million andrestructuring costs of $1.3 million, which were partially offset by netproceeds from sales of $2.8 million and the increase in accounts payable andaccrued liabilities discussed below.

 

The $1.5 million increase in accounts payable and accrued liabilitiesprimarily reflects an increase of $700,000 for accrued reorganization costs,and increases in accrued amounts for other professional fees and Brightwaterproject construction.

 

**Off Balance 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 March 31, 2010, we have no land option deposits and nothird party guarantees.

 

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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.

 

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 of March 31,2010, 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 onhome sales. Increases in home mortgage interest rates make it more difficultfor our customers to qualify for home mortgage loans, potentially decreasinghome sales revenue. Increases in interest rates also may affect adversely thevolume of mortgage loan originations. Increases in competition and the supplyof unsold new and existing homes have had an adverse effect on our ability togenerate new home orders and maintain home orders in backlog, and have had asignificant negative impact on our results of operations and gross margins onhome sales in our 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.

 

**Item3.  Quantitative and QualitativeDisclosures 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 March 31, 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.

 

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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.”

 

**Item4.  Controls and Procedures**

 

*Conclusion Regarding theEffectiveness 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) and 15d-15(e) underthe Securities Exchange Act of 1934, as amended) as of the end of the periodcovered by this report (the “Evaluation Date”). Based on that evaluation, ourchief executive officer and chief financial officer concluded that, as of theEvaluation Date, our disclosure controls and procedures were effective toensure that information required to be disclosed in our reports under theExchange Act, is recorded, processed, summarized and reported within the timeperiods specified in the SEC’s rules and forms, and that such informationis accumulated and communicated to management, including our chief executiveofficer and chief financial officer, as appropriate to allow timely decisionsregarding 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.

 

*Changes in Internal Controls*

 

There have been nochanges in our internal control over financial reporting during the threemonths ended March 31, 2010 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

**PART II - OTHER INFORMATION**

 

**Item 1.    Legal Proceedings.**

 

See Notes 8 and 10 to theConsolidated Financial Statements above, and Item 1 - Business - CorporateIndemnification Matters and Item 3 - Legal Proceedings in our Annual Report on Form 10-Kfor the year ended December 31, 2009.

 

**Item 6.****   ****Exhibits.**

 
| 10.05 |   | California  Coastal Communities, Inc. 401(k) Plan and Trust Agreement dated  effective April 30, 2010.                                                      |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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 being furnished solely toaccompany this report pursuant to 18 U.S.C. Section 1350, and are notbeing filed for purposes of Section 18 of the Securities Exchange Act of1934, as amended, and are not to be incorporated by reference into any filingof the Company, whether made before or after the date hereof, regardless of anygeneral incorporation language in such filing.

 

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**SIGNATURE**

 

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

 

 
| Date: May 13, 2010 | CALIFORNIA COASTAL  COMMUNITIES, INC. |
|-------------------------|---------------------------------------|
|                    |                                  |   |
|                    |                                  |   |
|                    | By:                                   | */s/ Sandra G. Sciutto* |
|                    |                                  | SANDRA G. SCIUTTO |
|                    |                                  | Senior Vice President and |
|                    |                                  | Chief Financial Officer |

 

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