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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 September 30, 2010**

** **

**OR**

** **

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

** **

**For the transition periodfrom                       to**

 

**Commissionfile number: 0-17189**

 

**CALIFORNIACOASTAL COMMUNITIES, INC.**

(Exact name of registrant asspecified in its charter)

 

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

 

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

 

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

 

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

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reporting company. Seedefinitions of  “large accelerated filer,”  “accelerated filer,” and “smaller reportingcompany” 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 November 1, 2010 there were 10,995,902 shares of CommonStock, par value $.05 outstanding

 

 

 

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**CALIFORNIA COASTAL COMMUNITIES, INC.**

 

**(DEBTOR-IN-POSSESSION)**

 

**FORM 10-Q**

 

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

 

**INDEX**

 
| Cautionary Statement About Forward-Looking Statements | 3                       |
|-------------------------------------------------------|-------------------------|
|                                                  |                    |   |   |
| Part I -                                         | Financial  Information: | 5 |
|                                                  |                    |   |   |
|                                                  | Item 1.                 | Consolidated  Financial Statements | 5 |
|                                                  |                    |   |   |
|                                                  |                    | Consolidated Balance Sheets — September 30, 2010  (unaudited) and December 31, 2009 | 5 |
|                                                  |                    |   |   |
|                                                  |                    | Consolidated Statements of Operations - Three and Nine  Months Ended September 30, 2010 and 2009 (unaudited) | 6 |
|                                                  |                    |   |   |
|                                                  |                    | Consolidated Statements of Cash Flows - Nine Months  Ended September 30, 2010 and 2009 (unaudited) | 7 |
|                                                  |                    |   |   |
|                                                  |                    | Notes to Consolidated Financial Statements | 8 |
|                                                  |                    |   |   |
|                                                  | Item 2.                 | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 24 |
|                                                  |                    |   |   |
|                                                  | Item 3.                 | Quantitative  and Qualitative Disclosures About Market Risk | 41 |
|                                                  |                    |   |   |
|                                                  | Item 4.                 | Controls and  Procedures | 41 |
|                                                  |                    |   |   |
| Part II -                                        | Other Information:      | 41 |
|                                                  |                    |   |   |
|                                                  | Item 1.                 | Legal Proceedings | 41 |
|                                                  |                    |   |   |
|                                                  | Item 6.                 | Exhibits | 41 |
|                                                  |                    |   |   |
| SIGNATURE                                             | 42                      |

 

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**CAUTIONARYSTATEMENT ABOUT FORWARD-LOOKING STATEMENTS**

 

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

 

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

 

·                  the impact,effect and eventual result of the Chapter 11 Cases in restructuring our debtobligations under the Revolving Loan and Term Loan;

 

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

 

·                  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;

 

·      the potential for additional real estateimpairment charges;

 

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

 

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

 

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

 

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

 

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

 

·                  our ability to deliver homesfrom backlog;

 

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

 

·                  our ability to securematerials and subcontractors;

 

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

 

·                  our cost of and ability toaccess additional capital;

 

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

 

·                  our ability to continuerelationships with current or future partners;

 

·                  the effectiveness andadequacy of our disclosure and internal controls;

 

·                  the impact of recentaccounting pronouncements; and

 

·                  stock market valuations.

 

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

 

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

 

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

 

Forward-lookingstatements speak only as of the date they are made and we assume no, and herebydisclaim any, obligation to update any of the foregoing or any otherforward-looking statements, whether as a result of new information, future events,changed circumstances or any other reason after the date of thisForm 10-Q. We nonetheless reserve the right to make such updates from timeto time by press release, periodic report or other method of public disclosurewithout the need for specific reference to this Form 10-Q or any otherreport filed by us. No such update shall be deemed to indicate that otherstatements not addressed by such update remain correct or create an obligationto provide any other updates.

 

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** **

**PART I - FINANCIALINFORMATION**

 

**Item 1.  Financial Statements.**

 

CALIFORNIA COASTAL COMMUNITIES, INC.

 

(DEBTOR-IN-POSSESSION)

 

CONSOLIDATED BALANCE SHEETS

 

(unaudited)

 

(in millions)

 
| ** **                                                                                                | ** ** | **September 30,  2010** | ** **  | **December 31,  2009** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|------------------------------|-------------|-----------------------------|------------|
| ** **                                                                                                | ** ** | ** **                   | ** **  | ** **                  | ** ** |
| ASSETS                                                                                                    | ** ** | ** **                   | ** **  | ** **                  | ** ** |
| ** **                                                                                                | ** ** | ** **                   | ** **  | ** **                  | ** ** |
| Cash and cash equivalents                                                                                 |       | $                            |  3.0   |                        | $          |  8.9 |   |
| Restricted cash                                                                                           |       | 0.8                          |        | 0.8                         |       |
| Real estate inventories                                                                                   |       | 225.1                        |        | 235.4                       |       |
| Other assets, net                                                                                         |       | 2.3                          |        | 4.8                         |       |
|                                                                                                      |       |                         |        |                        |       |
|                                                                                                      |       | $                            |  231.2 |                        | $          |  249.9 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                 | ** ** | ** **                   | ** **  | ** **                  | ** ** |
| ** **                                                                                                | ** ** | ** **                   | ** **  | ** **                  | ** ** |
| Liabilities not subject to compromise:                                                                    |       |                         |        |                        |       |
| Accounts payable and accrued liabilities                                                                  |       | $                            |  4.9   |                        | $          |  2.9 |   |
| Model home financing                                                                                      |       | 22.5                         |        | 22.5                        |       |
| Other liabilities                                                                                         |       | 1.6                          |        | 0.4                         |       |
|                                                                                                      |       |                         |        |                        |       |
| Total liabilities not subject to compromise                                                               |       | 29.0                         |        | 25.8                        |       |
|                                                                                                      |       |                         |        |                        |       |
| Liabilities subject to compromise:                                                                        |       |                         |        |                        |       |
| Accounts payable and accrued liabilities                                                                  |       | 1.1                          |        | 0.9                         |       |
| Revolving loan                                                                                            |       | 81.7                         |        | 81.7                        |       |
| Term loan                                                                                                 |       | 99.8                         |        | 99.8                        |       |
| Other liabilities                                                                                         |       | 8.4                          |        | 8.3                         |       |
|                                                                                                      |       |                         |        |                        |       |
| Total liabilities subject to compromise                                                                   |       | 191.0                        |        | 190.7                       |       |
|                                                                                                      |       |                         |        |                        |       |
| Commitments and contingencies                                                                             |       |                         |        |                        |       |
|                                                                                                      |       |                         |        |                        |       |
| Stockholders’ equity:                                                                                |       |                         |        |                        |       |
| Common Stock—$.05 par value; 13,500,000 shares  authorized; 10,995,902 shares issued and outstanding |       | 0.5                          |        | 0.5                         |       |
| Excess Stock—$.05 par value; 13,500,000 shares  authorized; no shares outstanding                    |       | —                       |        | —                      |       |
| Additional paid-in capital                                                                                |       | 59.6                         |        | 59.5                        |       |
| Accumulated deficit                                                                                       |       | (46.3                        | )           | (24.0                       | )          |
| Accumulated other comprehensive loss, net                                                                 |       | (2.6                         | )           | (2.6                        | )          |
| Total stockholders’ equity                                                                           |       | 11.2                         |        | 33.4                        |       |
|                                                                                                      |       |                         |        |                        |       |
|                                                                                                      |       | $                            |  231.2 |                        | $          |  249.9 |   |

 

See the accompanying notes to Consolidated Financial Statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

(DEBTOR-IN-POSSESSION)

 

CONSOLIDATED STATEMENTS OFOPERATIONS

 

(in millions, except per share amounts)

 

(unaudited)

 
| ** **                                    | ** ** | **Three Months Ended  September 30,** | ** **  | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------|-------------|-----------------------------------------------------|------------|
| ** **                                    | ** ** | **2010**                                             | ** **  | **2009**                                            | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                    | ** ** | ** **                                           | ** **  | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues:                                     |       |                                                 |        |                                                |       |   |   |   |   |
| Homebuilding                                  |       | $                                                    |  5.6   |                                                | $          |  9.6 |   | $ |  16.3 |   | $ |  32.9 |   |
| Land sales                                    |       | —                                               |        | 1.8                                                 |       | 1.4 |   | 1.8 |   |
|                                          |       | 5.6                                                  |        | 11.4                                                |       | 17.7 |   | 34.7 |   |
|                                          |       |                                                 |        |                                                |       |   |   |   |   |
| Costs of sales:                               |       |                                                 |        |                                                |       |   |   |   |   |
| Homebuilding                                  |       | 5.0                                                  |        | 8.0                                                 |       | 15.0 |   | 25.4 |   |
| Land sales                                    |       | —                                               |        | 1.8                                                 |       | — |   | 1.8 |   |
| Loss on impairment of real estate inventories |       | 8.0                                                  |        | —                                              |       | 14.0 |   | 3.2 |   |
|                                          |       | 13.0                                                 |        | 9.8                                                 |       | 29.0 |   | 30.4 |   |
|                                          |       |                                                 |        |                                                |       |   |   |   |   |
| Gross operating (loss) profit                 |       | (7.4                                                 | )           | 1.6                                                 |       | (11.3 | ) | 4.3 |   |
|                                          |       |                                                 |        |                                                |       |   |   |   |   |
| Selling, general and administrative expenses  |       | 1.0                                                  |        | 1.1                                                 |       | 3.2 |   | 3.6 |   |
| Reorganization costs                          |       | 2.3                                                  |        | —                                              |       | 6.0 |   | — |   |
| Interest expense                              |       | 0.1                                                  |        | —                                              |       | 0.1 |   | 0.8 |   |
| Gain on debt restructuring                    |       | —                                               |        | (4.1                                                | )          | — |   | (24.8 | ) |
| Other expense, net                            |       | 1.3                                                  |        | 1.1                                                 |       | 1.6 |   | 1.8 |   |
|                                          |       |                                                 |        |                                                |       |   |   |   |   |
| (Loss) income before income taxes             |       | (12.1                                                | )           | 3.5                                                 |       | (22.2 | ) | 22.9 |   |
|                                          |       |                                                 |        |                                                |       |   |   |   |   |
| Income tax expense                            |       | 0.1                                                  |        | 21.6                                                |       | 0.1 |   | 37.1 |   |
|                                          |       |                                                 |        |                                                |       |   |   |   |   |
| Net loss                                      |       | $                                                    |  (12.2 | )                                                   | $          |  (18.1 | ) | $ |  (22.3 | ) | $ |  (14.2 | ) |
|                                          |       |                                                 |        |                                                |       |   |   |   |   |
| Net loss per common share:                    |       |                                                 |        |                                                |       |   |   |   |   |
|                                          |       |                                                 |        |                                                |       |   |   |   |   |
| Basic and diluted                             |       | $                                                    |  (1.11 | )                                                   | $          |  (1.65 | ) | $ |  (2.03 | ) | $ |  (1.29 | ) |
|                                          |       |                                                 |        |                                                |       |   |   |   |   |
| Common equivalent shares:                     |       |                                                 |        |                                                |       |   |   |   |   |
|                                          |       |                                                 |        |                                                |       |   |   |   |   |
| Basic and diluted                             |       | 11.0                                                 |        | 11.0                                                |       | 11.0 |   | 11.0 |   |

 

See the accompanying notes to Consolidated Financial Statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

(DEBTOR-IN-POSSESSION)

 

CONSOLIDATED STATEMENTS OFCASH FLOWS

 

(in millions)

(unaudited)

 
| ** **                                                                       | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2010**                                            | ** ** | **2009** | ** ** |
|                                                                             |       |                                                |       |   |   |
| Cash flows from operating activities:                                            |       |                                                |       |   |   |
| Net loss                                                                         |       | $                                                   | (22.3      | ) | $ | (14.2 | ) |
| Adjustments to reconcile net loss to cash used in  operating activities:         |       |                                                |       |   |   |
| Gain on debt restructuring                                                       |       | —                                              |       | (24.8 | ) |
| Model homes depreciation                                                         |       | 0.2                                                 |       | 0.2 |   |
| Deferred taxes                                                                   |       | (8.3                                                | )          | 8.9 |   |
| Deferred tax asset valuation allowance                                           |       | 8.4                                                 |       | 28.2 |   |
| Gains on sales of real estate inventories and land                               |       | (2.6                                                | )          | (7.5 | ) |
| Loss on impairment of real estate inventories                                    |       | 14.0                                                |       | 3.2 |   |
| Proceeds from sale of real estate inventories and  land, net                     |       | 17.0                                                |       | 33.6 |   |
| Increase in real estate inventories                                              |       | (17.0                                               | )          | (21.8 | ) |
| Accrued or prepaid reorganization costs                                          |       | 1.0                                                 |       | — |   |
| Changes in assets and liabilities:                                               |       |                                                |       |   |   |
| Decrease in other assets                                                         |       | 1.0                                                 |       | 1.3 |   |
| Increase in accounts payable, accrued and other  liabilities                     |       | 2.7                                                 |       | 0.3 |   |
|                                                                             |       |                                                |       |   |   |
| Cash (used in) provided by operating activities                                  |       | (5.9                                                | )          | 7.4 |   |
|                                                                             |       |                                                |       |   |   |
| Cash flows from investing activities:                                            |       |                                                |       |   |   |
| Change in restricted cash                                                        |       | —                                              |       | 0.4 |   |
|                                                                             |       |                                                |       |   |   |
| Cash provided by investing activities                                            |       | —                                              |       | 0.4 |   |
|                                                                             |       |                                                |       |   |   |
| Cash flows from financing activities:                                            |       |                                                |       |   |   |
| Borrowings of revolving loan                                                     |       | —                                              |       | 26.5 |   |
| Repayments of revolving loan                                                     |       | —                                              |       | (19.2 | ) |
| Repayments of term loan                                                          |       | —                                              |       | (7.6 | ) |
| Repayments of other project debt                                                 |       | —                                              |       | (5.9 | ) |
| Deferred financing costs                                                         |       | —                                              |       | (0.2 | ) |
|                                                                             |       |                                                |       |   |   |
| Cash used in financing activities                                                |       | —                                              |       | (6.4 | ) |
|                                                                             |       |                                                |       |   |   |
| Net (decrease) increase in cash and cash  equivalents                            |       | (5.9                                                | )          | 1.4 |   |
|                                                                             |       |                                                |       |   |   |
| Cash and cash equivalents - beginning of period                                  |       | 8.9                                                 |       | 2.3 |   |
|                                                                             |       |                                                |       |   |   |
| Cash and cash equivalents - end of period                                        |       | $                                                   | 3.0        |   | $ | 3.7 |   |
|                                                                             |       |                                                |       |   |   |
| Supplemental disclosures of cash flow information:                               |       |                                                |       |   |   |
| Cash paid or received during the period for income  taxes                        |       | $                                                   | 1.0        |   | $ | 0.1 |   |
| Cash paid during the period for reorganization  items                            |       | 4.4                                                 |       | — |   |
|                                                                             |       |                                                |       |   |   |
| Supplemental disclosures of non-cash investing and  financing activities:        |       |                                                |       |   |   |
| Amortization of deferred financing costs  capitalized in real estate inventories |       | $                                                   | 1.3        |   | $ | 1.7 |   |
| Decrease in project debt and accrued liabilities  due to debt restructuring      |       | $                                                   | —     |   | $ | 32.8 |   |

 

See the accompanying notes to Consolidated Financial Statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

(DEBTOR-IN-POSSESSION)

 

NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS

(UNAUDITED)

 

**Note 1- Basis of Presentation**

 

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

 

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

 

*GoingConcern and Financial Reporting in Reorganization*

 

Whilethe Company is striving to 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 successful in that regard.Unless the Company is successful in executing a bankruptcy reorganization plan,or otherwise amending and extending the terms of the Revolving Loan and TermLoan agreements, the Company does not believe that its cash, cash equivalentsand future real estate sales proceeds will provide sufficient liquidity to meetits current debt obligations under the current terms of the existing RevolvingLoan agreement and Term Loan agreement as described in Notes 5 and 6, inaddition to meeting anticipated operating and project development costs forBrightwater, and general and administrative expenses during the next12 months. These factors raise substantial doubt about the Company’sability to continue as a going concern unless the Company is successful inreplacing or restructuring its Revolving Loan and Term Loan debt throughconfirmation of a plan of reorganization in the Chapter 11 Cases.

 

Theaccompanying Consolidated Financial Statements have been prepared assuming thatthe Company will continue as a going concern and contemplate the realization ofassets and the satisfaction of liabilities in the normal course of business. Asa result of the Chapter 11 reorganization process described below, therealization of assets and the satisfaction of liabilities are subject touncertainty. While operating as “debtors-in-possession” under Chapter 11, theCompany and the other Debtors described below may sell or otherwise dispose ofor liquidate assets or settle liabilities, subject to the approval of theBankruptcy Court or as otherwise permitted in the ordinary course of business,in amounts other than those reflected in the accompanying ConsolidatedFinancial Statements. Further, a plan of reorganization could materially changethe amounts and classifications of assets and liabilities in the historicalconsolidated financial statements. The accompanying Consolidated FinancialStatements do not include any direct adjustments related to the recoverabilityand classification of assets or the amounts and classification of liabilitiesor any other adjustments that might be necessary should the Company be unableto continue as a going concern or as a consequence of the Chapter 11 Cases.

 

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

 

*Overview*

 

OnOctober 27, 2009, the Company and certain of its direct and indirectwholly-owned subsidiaries (collectively with the Company, the “Debtors”) filedvoluntary petitions (the “Chapter 11 Petitions”) for relief under chapter 11 oftitle 11 (“Chapter 11”) of the United States Code (the “Bankruptcy Code”) inthe United States Bankruptcy Court for the Central 

 

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Districtof California (the “Bankruptcy Court”). The Chapter 11 Petitions are beingjointly administered under the caption *In re California CoastalCommunities, Inc.*, Case No. 09-21712-TA (the “Chapter 11Cases”). The Debtors continue to operate their businesses and manage theirproperties as “debtors-in-possession” under the jurisdiction of the BankruptcyCourt and in accordance with the applicable provisions of the Bankruptcy Codeand orders of the Bankruptcy Court. The Debtors have obtained the BankruptcyCourt’s approval to, among other things, continue to pay post-petition vendors,sell homes free and clear of all liens on an interim basis, use cash collateralon an interim basis, honor homeowner warranties, meet payroll obligations andprovide employee benefits. There can be no assurance that the Company and theother Debtors will be able to successfully develop, execute, confirm andconsummate one or more plans of reorganization with respect to the Chapter 11Cases that are acceptable to the Bankruptcy Court and the creditors and otherparties in interest, or continue to operate as debtors-in-possession until theChapter 11 Cases have been fully adjudicated.

 

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

 

*Plansof Management*

 

OnMarch 26, 2010, the Company filed a proposed disclosure statement andproposed joint plan of reorganization with the Bankruptcy Court and a hearingon the adequacy of the disclosure statement was held on May 12, 2010.Subsequently, on June 18, 2010, the Company obtained a financingcommitment from Luxor Capital Group, LP (“Luxor”) to provide $184 million ofnew debt financing and on July 2, 2010 filed a revised disclosurestatement and proposed joint plan of reorganization, which were further revisedon July 28, 2010. On August 31, 2010, the Luxor financing commitmentexpired.

 

TheCompany is continuing to negotiate with its lenders to develop a consensual planof reorganization, however there can be no assurance that the Company and theother Debtors will be able to successfully confirm, consummate and execute aplan of reorganization with respect to the Chapter 11 Cases in a manner that isacceptable to the Bankruptcy Court and the creditors and other parties ininterest.

 

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TheCompany and the other Debtors continue to operate their business asdebtors-in-possession. The Company has incurred and will continue to incursignificant costs associated with the reorganization which are expected tosignificantly affect the Company’s results of operations. During the ninemonths ended September 30, 2010, the Company incurred reorganization costsaggregating approximately $6.0 million and has incurred total reorganizationcosts of $7.3 million through such date.

 

The Company’s liquidity and capital resources are significantlyaffected by the Chapter 11 Cases, which have resulted in various restrictionson its activities, limitations on financing and the requirement of obtainingBankruptcy Court approval for various matters. In particular, the Debtors arenot permitted to make any payments on pre-petition liabilities without priorBankruptcy Court approval. However, the Debtors have been granted relief inorder to continue wage and salary payments and other employment benefits toemployees as well as other related pre-petition obligations; to continue toconstruct and sell homes; and to pay certain pre-petition trade claims held bycritical vendors with lien rights. The Company’s authorization to continue touse cash collateral and to sell homes free and clear of liens is currentlyscheduled to terminate on December 3, 2010.

 

Underthe priority schedule established by the Bankruptcy Code, certain post-petitionand pre-petition liabilities need to be satisfied before general unsecuredcreditors are entitled to receive any distribution.  At this time, it is not possible to predictwith certainty the effect of the Chapter 11 Cases on the Company’s business, orwhen the Company will emerge from these proceedings. Future results will dependupon the confirmation and successful implementation of a plan ofreorganization. The continuation of the Chapter 11 Cases, particularly if aplan of reorganization is not timely confirmed, could further adversely affectthe Company’s operations.

 

TheCompany depends on cash flows generated from operations to fund its Brightwaterdevelopment, and to meet its debt service and working capital requirements.However, the Company’s ability to continue to generate sufficient cash flowshas been and will continue to be adversely affected by continued difficultiesin the homebuilding industry, continued weakness in the California economy, andnegative publicity and prospective homebuyer concerns related to the Chapter 11Cases. While the Company generated 31 net sales orders in the first nine monthsof 2009, it generated only 10 net sales orders at Brightwater during thecomparable period of 2010, which the Company believes reflects the negativeimpact of the Chapter 11 Cases, as well as continued economic uncertainties,high unemployment and a general downturn in the housing market in the middle of2010.

 

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 before and afterit emerges from bankruptcy. There can be no assurance that the Company 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 the ability of theCompany to secure additional financing, and the terms of such financing if itis available.  The current housing andmortgage 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.

 

Basedon Brightwater sales in 2009 and the first nine months of 2010, unless theCompany is successful in executing a plan of reorganization in the Chapter 11Cases, the Company does not believe that its cash, cash equivalents and futurereal estate sales proceeds will provide sufficient liquidity to meet itscurrent debt obligations under the current terms of the existing Revolving LoanAgreement and Term Loan Agreement as described in Notes 5 and 6, in addition toits anticipated operating and project development costs for Brightwater, andgeneral and administrative expenses during the next 12 months. Thesefactors raise substantial doubt about the Company’s ability to continue as agoing concern unless the Company is successful in replacing or restructuringits Revolving Loan and Term Loan debt through confirmation of a plan ofreorganization in the Chapter 11 Cases, as described above. The ConsolidatedFinancial Statements herein do not include any adjustments that might resultfrom the outcome of this uncertainty.

 

*LiabilitiesSubject to Compromise*

 

Liabilitiessubject to compromise refers to pre-petition obligations which may be impactedby the Chapter 11 Cases. These amounts represent the Company’s current estimateof known or potential pre-petition obligations to be resolved in connectionwith the Chapter 11 Cases. Differences between estimated liabilities and theclaims filed will be investigated and resolved in connection with the claimsresolution 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.

 

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*ReorganizationCosts*

 

Reorganizationcosts include legal and professional fees incurred in connection with theChapter 11 Cases. During the three and nine months ended September 30,2010, the Company incurred $2.3 million and $6.0 million, respectively, ofreorganization costs and paid approximately $2.5 million and $4.4 million,respectively, of such costs. The Company has incurred total reorganizationcosts of $7.3 million from October 2009 through September 30, 2010.

 

*Over-the-CounterMarket*

 

OnApril 27, 2010, the Company’s common stock commenced trading under thesymbol “CALCQ.” in the OTCQB marketplace for Over-The-Counter stocks registeredon the Securities and Exchange Commission which are current on registrationfilings. The Company’s common stock was delisted from the Nasdaq Stock Marketat the open of trading on April 27, 2010 as a result of the Company’sinability to emerge from the Chapter 11 process by April 26.  The trading of the Company’s common stock inthe over-the-counter market rather than on Nasdaq may negatively impact thetrading price and the levels of liquidity available to its stockholders. Inaddition, securities that trade over-the-counter are not eligible for marginloans and will make the Company’s common stock subject to the provisions of Rule 15g-9of the Securities Exchange Act of 1934, as amended, commonly referred to as the“penny stock rule.”

 

**Note 3- Significant Accounting Policies**

 

*Basis of Consolidation*

 

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

 

*Consequencesof Chapter 11 Cases*

 

Financial Accounting Standards Board (“FASB”) Accounting Standards Codification(“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 quarterended December 31, 2009. The balance sheet must distinguish pre-petitionliabilities subject to compromise from both those pre-petition liabilities thatare not subject to compromise and from post-petition liabilities. Liabilitiesthat may be affected by a plan of reorganization must be reported at theamounts expected to be allowed, even if they may be settled for lesser amounts.In addition, cash provided or used by reorganization items must be disclosedseparately in the statement of cash flows. The Company applied ASC 852-10-45effective on October 27, 2009 and is segregating those items as outlinedabove for all reporting periods subsequent to such date.

 

*Subsequent Events*

 

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

 

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* *

*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 a plan of reorganization can becompleted. The Company, like many other homebuilders, is constantly evaluatingpotential alternatives regarding its capital structure including, but notlimited to, various strategies for restructuring its debt and raisingadditional capital. There can be no assurance that the Company will besuccessful in any of these endeavors. The limited credit availability for smallbusinesses presents uncertainty as to the ability of the Company to secureadditional financing and the terms of such financing if it is available, and asto the ability of the Company to achieve positive cash flow from operationsrequired to satisfy its obligations.  SeeNotes 5 and 6 below for further discussion.

 

*Real Estate*

 

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

 

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

 

*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 and nine months ended September 30, 2010, theCompany recorded impairment charges of $8.0 million and $14.0 million,respectively on the Brightwater project. See Note 4 — Real Estate Inventories.During the comparable periods in 2009, the Company recorded zero Brightwaterproject impairment charges and inland project impairment charges totaling zeroand $3.2 million, respectively.

 

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

 

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

 

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*Fair Value of Financial Instruments*

 

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

 

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

 
| **Description**         | ** ** | **Fair Value   Hierarchy** | ** ** | **Fair Value** | ** ** | **Impairment Charges for   the Nine Months Ended   September 30, 2010** | ** ** |
|-------------------------|------------|--------------------------------------|------------|---------------------|------------|----------------------------------------------------------------------------------------------------------------------|------------|
| Real estate inventories |       | Level 3                              |       | $                   | 219.4      |                                                                                                                 | $          | 14.0 |   |
|                         |            |                                      |            |                     |            |                                                                                                                      |            |  |  |

 

In accordance with ASC 360, real estate inventories with a carryingvalue of $233.0 million were determined to be impaired during the three monthsended June 30, 2010 and further impaired during the three months ended September 30,2010, resulting in a year-to-date impairment charge of $14.0 million which isreflected in cost of sales.  TheBrightwater inventories were written down to their estimated fair value of$219.4 million, after net additions of $400,000 during the three months ended September 30,2010.  See “*Impairmentof Real Estate Inventories*” above and Note 4 — Real EstateInventories.

 

*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 the financialstatement and tax bases of assets and liabilities, using enacted tax rates ineffect in the years in which these differences are expected to reverse. Theliability method requires an evaluation of the probability of being able torealize 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. 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 and nine months ended September 30, 2010, theCompany recorded valuation allowance adjustments on deferred tax assetstotaling $5.0 million and $8.4 million, respectively. During the comparableperiods in 2009, the Company recorded valuation allowance adjustments ondeferred tax assets totaling $20.6 million and $28.2 million, respectively. SeeNote 9—Income Taxes.

 

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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 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 under ASC740-10 as it represents uncertainties related to future projected taxableincome. Additionally, there are critical uncertainties as to whether theCompany will be able to continue selling homes at its Brightwater project usingcurrently projected sales prices and absorption rates in light of thecontinuing deterioration in the housing and credit markets. If the Companyutilizes a portion of its NOLs or certainty increases regarding the Company’suse of its NOLs due to projected results of operations and there is objectivelyverifiable evidence to support the expected realization of a portion of itsdeferred tax assets, an adjustment to the Company’s valuation allowance may berecorded to reflect greater expected utilization. In addition, if an ownershipchange occurs as a result of the Company’s emergence from Chapter 11, theutilization of tax net operating losses in the carryforward period is likely tobe materially jeopardized.

 

*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.

 

*Loss Per Common Share*

 

Loss per common share is accounted for in accordance with ASC 260-10, “*Earnings Per Share*.” Basic earnings (loss)per common share is computed using the weighted-average number of common sharesoutstanding for the period. Diluted earnings per common share is computed usingthe weighted-average number of common shares outstanding and the dilutiveeffect 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 ofSeptember 30, 2010, real estate inventories aggregated 279 lots and homes,including 17 model homes, 10 standing inventory homes completed and unsold,three homes completed and in escrow, two homes under construction and in escrowand two inventory homes under construction. Real estate inventories at September 30,2010 included $224.5 million recorded for 262 lots and homes underdevelopment and 17 model homes held under a financing lease at the Brightwatercommunity, as well as a five-acre project being planned for 22 homes outsidethe Brightwater community, which are located on a mesa north of the Bolsa Chicawetlands in Huntington Beach, California. The additional recorded value in realestate inventories reflects 73 lots at the Company’s subsidiary’s inlandproject in Lancaster, California. The Company capitalizes carrying costsincluding interest and property taxes, as well as direct construction costs, toreal estate inventories during the development and construction period.

 

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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.

 

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

 

During the three and nine months ended September 30, 2010, theCompany recorded impairment charges of $8.0 million and $14.0 million,respectively, with respect to its Brightwater project. During the three andnine months ended September 30, 2009, the Company recorded inland projectimpairment charges totaling zero and $3.2 million, respectively.

 

As required by ASC 360-10-35, should market conditions deteriorate inthe future or other events occur that indicate the carrying amount of 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.

 

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

 
| ** **                                | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                | ** ** | **2010**                                             | ** ** | **2009**                                            | ** ** | **2010** | ** ** | **2009** | ** ** |
| Capitalized interest, beginning of period |       | $                                                    | 40.7       |                                                | $          | 37.5 |   | $ | 36.8 |   | $ | 37.3 |   |
| Interest incurred and capitalized         |       | 2.9                                                  |       | 5.0                                                 |       | 9.0 |   | 12.2 |   |
| Charged to cost of sales                  |       | (1.2                                                 | )          | (2.9                                                | )          | (3.4 | ) | (5.7 | ) |
| Charged to gain on debt restructuring     |       | —                                               |       | (2.8                                                | )          | — |   | (7.0 | ) |
| Capitalized interest, end of period       |       | $                                                    | 42.4       |                                                | $          | 36.8 |   | $ | 42.4 |   | $ | 36.8 |   |

 

**Note 5 —Revolving Loan**

 

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

 

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

 

Interest on the facility is calculated on the average outstanding dailybalance and is paid monthly. Interest incurred on the Revolving Loan for thethree and nine months ended September 30, 2010 was $700,000 and $2.6million, respectively, at weighted-average interest rates of 3.56% and 3.53%,respectively. Interest incurred on the Revolving Loan for the three and ninemonths ended September 30, 2009 was $1.0 million and $3.2 million,respectively, at weighted-average interest rates of 3.54% and 3.67%,respectively.  Following the Company’s$1.7 million principal payment default, effective October 1, 2009,interest began to accrue at the default rate specified in the loan; however,under the terms of the Bankruptcy Court’s cash collateral order, the Companycontinued paying interest at the non-default rate of LIBOR + 3.25% and wascurrent on such interest payments as of September 30, 2010. On July 28,2010, the Bankruptcy Court approved a settlement agreement between the Debtors,the agent and the existing lenders that provided, among other things, that nodefault interest will be due.

 

As of September 30, 2010, the Company has delivered 94 homes atBrightwater since inception of the project, including the 17 model homesincluded in the sale-leaseback transaction completed on December 31, 2008and 14 homes (six Trails, one Sands, five Cliffs and two Breakers) deliveredduring the nine months ended September 30, 2010. Due to the Chapter 11Cases, no principal payments were made on the 24 homes delivered during thefourth quarter of 2009 and the first nine months of 2010.

 

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As of September 30, 2010 and December 31, 2009, approximatelyzero and $500,000, respectively, of deferred loan fees and closing costsrelated to the Revolving Loan are included in other assets and were amortizedover the expected life of the loan. Amortization of these costs is included inthe capitalization of interest allocated to real estate inventories and chargedto cost of sales when the related homes are delivered.

 

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

 

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

 

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

 

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

 

·                  A minimum liquidity covenantwhich requires the Company to maintain a minimum cash balance of $4.0 millionat all times.

 

·                  A prohibition on dividends.

 

As of September 30, 2010, the Company’s consolidated totalliabilities are $220.0 million, tangible net worth after excluding the 2009 and2008 inland impairment charges and valuation allowances on deferred tax assetsis $93.2 million and the leverage ratio is 2.36. 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 Term Loan.In addition, the Company’s unrestricted cash balance of $3.0 million as of September 30,2010, does not comply with its minimum liquidity requirement of $4.0million.  

 

While the sales pace at Brightwater was close to expectations at thebeginning of 2009, the mix of sales was heavily weighted towards smaller homeswhich are generating less liquidity than the larger homes.  The Company did not meet its mandatoryprincipal repayments due on September 30, 2009, December 31, 2009, orMarch 31, 2010 and was unable to fully repay the Revolving Loan by itscurrent maturity date on June 30, 2010 from cash flow fromoperations.  Through the Chapter 11reorganization process, the Company is striving to restructure its debt toincorporate payments that will 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 this endeavor.

 

**Note 6 —TermLoan**

 

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

 

As of September 30, 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, $15.0million, $10.0 million and $15.0 million due on December 31, 2009, March 31,2010, June 30, 2010 and September 30, 2010, respectively, resultingin an aggregate of $49.8 million of principal due and unpaid as of September 30,2010.

 

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Interest on the facility is calculated on the average outstanding dailybalance and is paid monthly. Interest incurred on the Term Loan for the three andnine months ended September 30, 2010 was $1.4 million and$4.0 million, respectively, at weighted-average interest rates of 4.31%and 4.28%, respectively. Interest incurred on the Term Loan for the three andnine months ended September 30, 2009 was $1.4 million and $4.6 million,respectively, at weighted-average interest rates of 4.29% and 4.61%,respectively.  Following the Company’s$1.7 million principal payment default on the Revolving Loan, effective October 1,2009, interest under the Term Loan began to accrue at the default ratespecified in the loan; however, under the terms of the Bankruptcy Court’s cashcollateral order, the Company continued paying interest at the non-default rateof LIBOR + 4.00% and was current on such interest payments as of September 30,2010. On July 28, 2010, the Bankruptcy Court approved a settlementagreement between the Debtors, the agent and the existing lenders thatprovided, among other things, that no default interest will be due.

 

The Term Loan is subject to mandatory repayments and commitmentreductions based on 60% of the $600,000 release price on the first 70 unitsclosed at the Brightwater project, and 60% of the $1.0 million releaseprice per unit thereafter. As of September 30, 2009, the Company haddelivered 70 homes. These mandatory repayments are applicable to the commitmentreductions.  However, due to the Chapter11 Cases, no principal payments were made on the additional 24 homes deliveredduring the fourth quarter of 2009 and first nine months of 2010.

 

As of September 30, 2010, the Company has delivered 94 homes atBrightwater since inception of the project, including the 17 model homesincluded in the sale-leaseback transaction completed on December 31, 2008and 14 homes (six Trails, two Sands, five Cliffs and one Breakers) deliveredduring the nine months ended September 30, 2010, and made cumulativemandatory repayments for the Term Loan of $25.2 million prior to thefiling of the Chapter 11 Cases.

 

As of September 30, 2010 and December 31, 2009, approximately$1.0 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. The calculationof the covenant excludes impairment charges related to inland projects andvaluation allowances on deferred tax assets.

 

·                  A loan-to-value ratio, whichprohibits the Company’s ratio of Term Loan debt outstanding to borrowing basevalue from exceeding a maximum ratio of 45% as of September 30, 2010 andthereafter, regarding which the Company has been notified it is in default.

 

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

 

·                  A minimum consolidatedtangible net worth covenant of $80 million, excluding impairment charges forinland projects and valuation allowances on deferred tax assets.

 

·                  A minimum liquidity covenantwhich requires the Company to maintain a minimum cash balance of $4.0 millionat all times.

 

·                  A prohibition on dividends.

 

As of September 30, 2010, the Company’s consolidated totalliabilities are $220.0 million, tangible net worth after excluding the2009 and 2008 inland impairment charges and valuation allowances on deferredtax assets is $93.2 million and the leverage ratio is 2.36. The Company is incompliance with the aforementioned covenants except for the loan-to-value andinterest coverage covenants. The Company was notified on September 28,2009 that it is not in compliance with the loan-to-value ratio covenant of theTerm Loan based on an August 2009 appraisal obtained by the agent for theRevolving Loan and Term Loan.  Inaddition, the Company’s unrestricted cash balance of $3.0 million as of September 30,2010, does not comply with its minimum liquidity requirement of $4.0million.  

 

While the sales pace at Brightwater was close to expectations at thebeginning of 2009, the mix of sales was heavily weighted towards smaller homeswhich are generating less liquidity than the larger homes. Therefore, theCompany did not make the mandatory repayments due on December 31, 2009, orMarch 31, June 30, or September 30, 2010. Through the Chapter 11reorganization process, the Company is striving to restructure its debt toincorporate payments that will accommodate the expected sales pace of theBrightwater project and provide sufficient liquidity to fund continued homeconstruction. There can be no assurance that the Company will be successful inthis endeavor.

 

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**Note 7—ModelHome Financing**

 

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

 

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

 

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 represents additionalcapital contributions that become payable upon the dissolution of the jointventure.

 

The model home lease allows the Company to utilize the 17 model homesfor continued customer display for a term of three years expiringDecember 31, 2011, with two renewal options for one year each. Inconnection with the Chapter 11 Cases, the Bankruptcy Court approved the Company’sassumption of this lease on September 29, 2010. During the three and ninemonths ended September 30, 2010, the Company made model home leasepayments totaling $788,000 and $2.4 million, respectively. Monthly leasepayments of $262,500 per month are due through December 2010, and $279,167per month in 2011.

 

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

 
| **Year** | ** ** | **Amount** | ** ** |
|----------|------------|------------|------------|
| 2010     |       | $          | 0.8        |   |
| 2011     |       | 3.3        |       |
| Total    |       | $          | 4.1        |   |

 

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

 

Asof September 30, 2010 and December 31, 2009, other liabilities notsubject to compromise included contingent indemnity and environmentalobligations totaling $1.6 million, including a reserve for the CaliforniaDepartment of Toxic Substances Control matter discussed below.

 

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Asof September 30, 2010 and December 31, 2009, other liabilitiessubject to compromise were comprised of the following (in millions):

 
| ** **                                         | ** ** | **Subject to Compromise** | ** ** |
|----------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                         | ** ** | **September 30,  2010**        | ** ** | **December 31,  2009** | ** ** |
| Accrued pensions and benefits                      |       | $                                   | 5.6        |   | $ | 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 | ) |
|                                               |       | $                                   | 8.4        |   | $ | 8.3 |   |

 

Accrued pensions and benefits includes the accrued benefit liabilityfor the Company’s defined benefit retirement plan for which the benefit accrualfor all participants was terminated on December 31, 1993.  Due to the prohibition on payments forprepetition liabilities in the Company’s Chapter 11 Cases, no assets have beencontributed to the plan during 2010. Contingent indemnity and environmental obligations primarily reflect (i) reservesbefore related discount (recorded pursuant to Fresh-Start Reporting in 1997)for contingent indemnity obligations for businesses disposed of by formeraffiliates and unrelated to the Company’s current operations and (ii) areserve recorded during the three months ended September 30, 2010 relatedto a claim by the California Department of Toxic Substances Control, discussedbelow.

 

*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.

 

A trial date in the District Court case has been set for November 16,2010.  After considering the legal costsof continuing to defend itself, HRC has determined that it will allow the DTSCto obtain a default judgment against it. The DTSC has already filed a proof of claim in the Bankruptcy Cases andwill presumably assert that the Company should pay the amount of the HRCdefault judgment under an alter ego theory of liability.  The Company believes that defending itselfagainst any prospective liability in the Bankruptcy Cases will be a betterallocation of resources and will have a greater likelihood of success thanfunding HRC to go to trial in the District Court.  While the Company does not believe the DTSChas a valid claim based on the merits of its case or under an alter ego theoryof liability, since HRC will allow the DTSC to obtain a default judgmentagainst it, applicable accounting rules require the Company to accrue forDTSC’s approximately $1.2 million of claims against HRC during the thirdquarter of 2010.

 

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

 

**Note 9- Income Taxes**

 

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

 
| ** **                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                   | ** ** | **2010**                                             | ** ** | **2009**                                            | ** ** | **2010** | ** ** | **2009** | ** ** |
| Current taxes                                |       | $                                                    | —     |                                                | $          | — |   | $ | — |   | $ | — |   |
| Deferred taxes                               |       | (4.9                                                 | )          | 1.0                                                 |       | (8.3 | ) | 8.9 |   |
| Valuation  allowances on deferred tax assets |       | 5.0                                                  |       | 20.6                                                |       | 8.4 |   | 28.2 |   |
| Income tax  expense                          |       | $                                                    | 0.1        |                                                | $          | 21.6 |   | $ | 0.1 |   | $ | 37.1 |   |

 

During 2009 and the first nine months 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 at economicallyviable prices, market conditions and other objectively verifiable economicfactors affecting the Company’s operations, as well as other positive andnegative factors, as it assesses valuation allowances against its deferred taxassets.

 

During the fourth quarter of 2009, the Company recorded a $950,000 taxreceivable for federal alternative minimum tax paid for years prior to 2009authorized by the November 2009 passage of the Worker, Homeownership andBusiness Assistance Act of 2009 which allows businesses with NOLs for 2008 and2009 to carry back losses for up to five years and suspends the 90% limitationon the use of any alternative tax NOL deduction attributable to carry backs ofthe applicable NOL. In June 2010, the Company filed a refund claim for theamount of the tax receivable and received the refund during the third quarterof 2010.

 

The federal NOLs available as of September 30, 2010 wereapproximately $166 million. The amount of federal NOLs which expire if notutilized is $49 million in 2010, $42 million in 2011, zero in 2012,2013 and 2014, and $75 million thereafter. 

 

Internal Revenue Code (the “Code”) Section 382 generally limitsthe availability of NOLs if an ownership change occurs.  The Code defines an ownership change as ashift of stock ownership of more than 50% generally within a three-year period.If the Company were to experience an ownership change, it would determine if ithas an overall net unrealized built-in gain (“NUBIG”) or overall net unrealizedbuilt-in loss (“NUBIL”).  Assuming theCompany has a NUBIG, the use of all remaining NOLs would generally be subjectto an annual limitation equal to (i) the value of the Company’s equitybefore the ownership change plus the increase in the value of the Companyresulting from any debt cancellation through the Chapter 11 Cases, multipliedby the long-term tax-exempt rate (3.86% as of November 2010) plus (ii) built-ingains recognized within five years of the ownership change, subject to anoverall limitation of the NUBIG. Assuming the company has a NUBIL, the use of NOLs (and other built-inlosses subject to an overall limitation of the NUBIL) would generally besubject to an annual limitation equal to the value of the Company’s equitybefore the ownership change plus the increase in the value of the Companyresulting from any debt cancellation through the Chapter 11 Cases, multipliedby the long-term tax-exempt rate (3.86% as of November 2010).  If the Company’s NUBIG or NUBIL is notgreater than the lesser of (a) 15% of the fair market value of its assetsor (b) $10 million, then the NUBIG or NUBIL is deemed to be zero.

 

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The Company estimates that after giving effect to various transactionsby stockholders who hold a 5% or greater interest in the Company, it hasexperienced a three-year cumulative ownership shift of approximately 44% as of November 1,2010, as computed in accordance with Section 382. The cumulative shiftincludes the effect of an approximate 15% ownership shift which occurred in thesecond quarter of 2010 upon the sale of a large stockholder’s position.  The Company’s net deferred tax assets arecurrently fully reserved due to the uncertainty of the timing and amount offuture taxable income.  If certaintyincreases regarding the Company’s use of its NOLs or projected results ofoperations and there is objectively verifiable evidence to support the expectedrealization of a portion of its deferred tax assets, an adjustment to theCompany’s valuation allowance may be recorded to reflect greater expectedutilization.  In addition, if anownership change occurs as a result of the Company’s emergence from Chapter 11,the utilization of tax net operating losses in the carryforward period islikely to be materially jeopardized.

 

InSeptember 2006, the Company’s Board of Directors suspended enforcement ofthe Company’s charter documents that restrict stockholders from acquiring morethan 5% of the outstanding shares of common stock. At that time, the Boarddetermined that such restrictions were not required to preserve the taxbenefits of the Company’s NOLs. However, transactions by holders of over 5% ofthe Company’s common stock during the past three years necessitated thereinstatement of this control in order to ensure that the 50% change inownership threshold is not exceeded which, under IRS rules, would severelylimit the Company’s use of its NOLs.  Therefore,on May 13, 2010, the Company reinstated a ban on acquisitions ofadditional shares of its common stock, under certain circumstances, in order topreserve the tax benefits of the Company’s $166 million of NOLs.  In accordance with provisions of the Company’scharter documents, unless the Company has previously consented in writing (i) nostockholder may acquire shares in an amount that would cause the stockholder toown 5% or more of the common stock; and (ii) no current 5% or greaterstockholder may acquire any additional shares of common stock.

 

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

 

*Uncertain Tax Positions*

 

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

 

Of the Company’s unrecognized tax benefits of $4.8 million at September 30,2010, $100,000 would decrease the Company’s effective tax rate if recognized.During the quarter ended September 30, 2010, the Company’s unrecognizedtax benefits decreased by approximately $100,000 as a result of the expirationof statutes of limitations. The Company expects that its unrecognized taxbenefits will decrease by approximately $1.4 million within 12 months of thereporting date due to statutes of limitation lapses.

 

The Company recognizes interest expense and penalties related touncertain tax positions as interest or other expense. As of September 30,2010, 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 2007through 2009 remain open for Federal purposes for which the Company utilizedNOLs generated in 1993 to offset taxable income. The years 2006 through 2009remain open for California purposes, during which time the Company utilizedNOLs generated in 2007.

 

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.

 

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**Note 10- Commitments and Contingencies**

 

*Real Estate Matters*

 

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

 

*Legal Proceedings - Other Litigation*

 

There are various lawsuits and claims pending against the Company andcertain subsidiaries including matters discussed in Note 8 above. In theopinion of the Company’s management, ultimate liability, if any, will not havea material adverse effect on the Company’s financial condition or results of operations.

 

*Corporate Indemnification Matters*

 

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

 

**Note 11— Stockholders’ Equity**

 

Asof September 30, 2010, total stockholders’ equity is $11.2 million,reflecting beginning stockholders’ equity of $33.4 million, net loss of $22.3million, and a $100,000 reduction in unrecognized tax benefits during the ninemonths ended September 30, 2010. 

 

**Note 12— Stock Plan**

 

*1993 Stock Option/Stock Issuance Plan*

 

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

 

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

 

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The Company did not grant any options during the nine months ended September 30,2010 and 2009. Pursuant to ASC 718-10, “*Compensation — StockCompensation*,” the Company recorded zero and $53,000 of compensationexpense during the nine months ended September 30, 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 nine monthsended September 30, 2010 follows:

 
| ** **                                        | ** ** | **Number of  Options** | ** ** | **Weighted-Average  Exercise  Price** | ** ** | **Weighted-Average  Remaining  Life** | ** ** |
|---------------------------------------------------|------------|-----------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| Outstanding, January 1                       |       | 17,500                      |       | $                                     | 21.58      | (a)                                   |       |   |
| Granted                                           |       | —                      |       | $                                     | —     |                                  |       |   |
| Exercised                                         |       | —                      |       | $                                     | —     |                                  |       |   |
| Outstanding, September 30                    |       | 17,500                      |       | $                                     | 21.58      | (a)                                   | 5.35 years |   |
|                                              |       |                        |       |                                  |       |                                  |       |
| Fully vested and exercisable at September 30 |       | 17,500                      |       | $                                     | 21.58      | (a)                                   | 5.35 years |   |
|                                              |       |                        |       |                                  |       |                                  |       |
| Available for future grants at September 30  |       | 221,794                     |       |                                  |       |                                  |       |

 

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(a)                                  Adjusted forspecial dividend of $12.50

 

As of September 30, 2010, there were 17,500 options outstandingwith a weighted-average exercise price of $21.58 (ranging from $13.35 to$25.99) and a weighted-average remaining life of 5.35 years. Alloutstanding stock options are fully vested. The aggregate intrinsic value ofall outstanding, fully-vested and exercisable stock options at September 30,2010 was zero.

 

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

 

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

 

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

 

**Status of Chapter 11 Cases**

 

OnOctober 27, 2009, California Coastal Communities, Inc. (“we”) andcertain of our direct and indirect wholly-owned subsidiaries (collectively withus, the “Debtors”) filed voluntary petitions (the “Chapter 11 Petitions”) forrelief under chapter 11 of title 11 (“Chapter 11”) of the United States Code(the “Bankruptcy Code”) in the United States Bankruptcy Court for the CentralDistrict of California (the “Bankruptcy Court”). The Chapter 11 Petitions arebeing jointly administered under the caption *In reCalifornia Coastal Communities, Inc.*, Case No. 09-21712-TA(the “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 paypost-petition vendors, sell homes free and clear of all liens on an interimbasis, use cash collateral on an interim basis, honor homeowner warranties,meet payroll obligations and provide employee benefits. There can be no assurancethat we and the other Debtors will be able to successfully develop, execute,confirm and consummate one or more plans of reorganization with respect to theChapter 11 Cases that are acceptable to the Bankruptcy Court and the creditorsand other parties in interest, or continue to operate as debtors-in-possessionuntil the Chapter 11 Cases have been fully adjudicated.

 

Wehave 13 direct or indirect consolidated subsidiaries which are not guarantorsof the $81.7 million Revolving Loan or the $99.8 million Term Loan and are notDebtors in the Chapter 11 Cases. These subsidiaries are former owners ofbusinesses unrelated to our current operations and have no current materialoperations.

 

OnMarch 26, 2010, we filed a proposed disclosure statement and proposedjoint plan of reorganization with the Bankruptcy Court and a hearing on theadequacy of the disclosure statement was held on May 12, 2010.Subsequently, on June 18, 2010, we obtained a financing commitment fromLuxor Capital Group, LP (“Luxor”) to provide $184 million of new debt financingand on July 2, 2010 filed a revised disclosure statement and proposedjoint plan of reorganization, which were further revised on July 28, 2010,with the Bankruptcy Court. On August 31, 2010, the Luxor financing commitmentexpired.

 

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Weare continuing to negotiate with our lenders to develop a consensual plan ofreorganization, however there can be no assurance that we and the other Debtorswill be able to successfully confirm, consummate and execute a plan of reorganizationwith respect to the Chapter 11 Cases in a manner that is acceptable to theBankruptcy Court and the creditors and other parties in interest.

 

Weand the other Debtors continue to operate our business asdebtors-in-possession. We have incurred and will continue to incur significantcosts associated with the reorganization which are expected to significantlyaffect our results of operations. During the nine months ended September 30,2010, we incurred reorganization costs aggregating approximately $6.0 millionand have incurred total reorganization costs of $7.3 million through such date.

 

We have maintained business operations through the reorganizationprocess. Our liquidity and capital resources, however, are significantlyaffected by the Chapter 11 Cases, which have resulted in various restrictionson our activities, limitations on financing and the requirement of obtainingBankruptcy Court approval for various matters. In particular, the Debtors arenot permitted to make any payments on pre-petition liabilities without priorBankruptcy Court approval. However, the Debtors have been granted relief inorder to continue wage and salary payments and other employment benefits toemployees as well as other related pre-petition obligations; to continue toconstruct and sell homes; and to pay certain pre-petition trade claims held bycritical vendors with lien rights. Our authorization to continue to use cashcollateral and to sell homes free and clear of liens is currently scheduled toterminate on December 3, 2010.

 

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

 

Wedepend on cash flows generated from operations to fund our Brightwaterdevelopment, and to meet our debt service and working capital requirements.However, our ability to continue to generate sufficient cash flows has been andwill continue to be adversely affected by continued difficulties in thehomebuilding industry, continued weakness in the California economy, andnegative publicity and prospective homebuyer concerns related to the Chapter 11Cases. While we generated 31 net sales orders in the first nine months of 2009,we generated only 10 net sales orders at Brightwater during the comparableperiod of 2010, which we believe reflects the negative impact of the Chapter 11Cases, as well as the continued economic uncertainties, high unemployment and ageneral downturn in the housing market in the middle of 2010.

 

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 or new financings can be obtained inorder for us to meet our debt obligations before and after we emerge frombankruptcy. There can be no assurance that we will be successful in any ofthese endeavors. While the national credit markets appear to be improving,there is limited availability of financing for small businesses which presentssignificant uncertainty as to our ability to secure additional financing, andthe terms of such financing if it is available. The current housing andmortgage markets also present significant uncertainty as to our ability toachieve sufficient positive cash flow from operations required to satisfy itsdebt obligations and meet financial covenant requirements. See Notes 5 and6 to the Consolidated Financial Statements for further discussion.

 

Based on Brightwater sales in 2009 and the first nine months of 2010,unless we are able to successfully execute a plan of reorganization withrespect to the Chapter 11 Cases, we do not believe that our cash, cashequivalents and future real estate sales proceeds will provide sufficientliquidity to meet our current debt obligations under the current terms of theexisting Revolving Loan Agreement and Term Loan Agreement as described in Notes5 and 6 to the Consolidated Financial Statements, in addition to ouranticipated operating and project development costs for Brightwater, andgeneral and administrative expenses during the next 12 months. Thesefactors raise substantial doubt about our ability to continue as a goingconcern unless we are successful in replacing or restructuring our RevolvingLoan and Term Loan debt through confirmation of a plan of reorganization in theChapter 11 Cases. The Consolidated Financial Statements herein do not includeany adjustments that might result from the outcome of this uncertainty.

 

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*Over-the-Counter Market*

 

OnApril 27, 2010 our common stock commenced trading under the symbol “CALCQ”in the OTCQB marketplace for Over-The-Counter stocks registered on theSecurities and Exchange Commission which are current on registrationfilings.  Our common stock was suspendedfrom trading on the Nasdaq Stock Market on April 27, 2010 because we hadnot emerged from the Chapter 11 process by April 26, 2010.  Our common stock was officially delisted on June 21,2010. The trading of our common stock in the over-the-counter market ratherthan on Nasdaq may negatively impact the trading price and the levels ofliquidity available to our stockholders. In addition, securities that tradeover-the-counter are not eligible for margin loans and will make our commonstock subject to the provisions of Rule 15g-9 of the Securities ExchangeAct of 1934, as amended, commonly referred to as the “penny stock rule.” 

 

**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 three months of 2010 our new home constructionwill be limited to our 356-home Brightwater project located on the Bolsa Chicamesa in Huntington Beach, California.

 

During the remaining three months of 2010, our primary goals will beto:

 

·                  propose a consensual plan ofreorganization to restructure our debt obligations which can be confirmed bythe Bankruptcy Court as soon as possible, and would enable us to emerge fromChapter 11 bankruptcy in early 2011; 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 September 30, 2010and 2009 were $5.6 million and $11.4 million, respectively and $17.7million and $34.7 million for the nine months ended September 30, 2010 and2009 respectively.  For the three monthsended September 30, 2010 and 2009, we delivered four and 21 homes,respectively. Our total assets as of September 30, 2010 andDecember 31, 2009 were $231.2 million and $249.9 million, respectively,with Brightwater and other nearby properties constituting $224.5 million (97%of total assets) and $234.8 million (94% of total assets), respectively. Ourhomebuilding subsidiary, Hearthside Homes, Inc., has delivered over 2,300homes to families 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 ourstockholders in September 2006. As of September 30, 2010, we had$204.0 million of debt (including the model homes lease) against$11.2 million of book equity.

 

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

 

**HomebuildingOutlook and Operating Strategy**

 

The housing market downturn that began in 2006 and accelerated when thefinancial crisis and economic recession began in 2007 has continued through thethird quarter of 2010. Specifically, the credit markets and the mortgageindustry have experienced a period of unparalleled turmoil and disruptioncharacterized by bankruptcy, declining home prices and restrained demand, lowconsumer confidence, high unemployment, financial institution failure,consolidation and an unprecedented level of intervention by the United Statesfederal government. This disruption of the credit markets has made it moredifficult for homebuyers to obtain acceptable financing, particularly forjumbo-mortgages. In addition, the supply of new and resale homes in themarketplace remained excessive in relation to the levels of consumer demand,particularly in light of record numbers of foreclosed homes which are beingoffered at substantially reduced prices. These pressures in the marketplaceforced homebuilders to use increased sales incentives and price reductions inan effort to generate sales and reduce inventory levels throughout 2009 and thefirst nine months of 2010.

 

Although the National Bureau of Economic Research recently concludedthat the national recession that began in December 2007 ended in June 2009,weakness in the homebuilding environment has continued as unemployment remainsat very high rates. Economic uncertainty and the lapse of government supportincentives for homebuyers continue to hamper the homebuilding industry, despitesome modest economic improvements.  Themain factors driving these conditions have been mounting sales of lender-ownedhomes acquired through mortgage foreclosures and short sales which has beenfueled by increasing mortgage delinquencies, greater voluntary or involuntarymortgage defaults, and the lifting to varying degrees of voluntary lenderforeclosure moratoriums; a generally weak economic and employment environment;tightened mortgage credit standards and reduced credit availability; tepidconsumer confidence; intense competition for home sales; and the actual orproposed winding down, reduction or reversal of government programs andpolicies supportive of home ownership. We expect these factors to continue tonegatively impact housing markets to varying degrees through the fourth quarterof 2010 and into 2011.

 

The broader homebuilding industry has experienced a continuouslydepressed level of new home sales, which we believe was exacerbated by ageneral hesitation in the national and global markets due to the oil spill inthe Gulf of Mexico; uncertainty of the European financial system; and declinesin the stock market earlier this year. Concern about the state of the economyand the job market continues to negatively affect consumer confidence, asunemployment rates continued to rise throughout 2009 in almost all of themetropolitan areas tracked by the U.S. Department of Labor. The unemploymentrate in California was 12.2% at both the end of the third quarter of 2010 andat the end of the third quarter of 2009, while the unemployment rate in OrangeCounty was 9.6% in September 2010 compared with 9.4% in September 2009.We believe that as long as these high unemployment rates continue, they will beone of the key barriers to commitment to a home-buying decision for ourpotential customers and will continue to impact the sales pace of the industryas a whole.

 

These adverse conditions have now persisted to varying degrees sincethe beginning of 2006 and their impact is reflected in our results for thefirst nine months of 2010 and 2009.  Webelieve the weak demand we are experiencing, particularly for homes over $1.5million, reflects the excess supply of higher end homes in the coastalHuntington Beach market, as well as homebuyers’ reluctance to make a purchasingdecision until they are comfortable that home prices have stabilized.  In addition, uncertainties surrounding futureeconomic growth and our continuing Chapter 11 Cases have suppressed our homesales.  The inventories of resale homesin the Huntington Beach coastal zip codes have been declining, reducing thesupply of resale homes with which Brightwater may compete, and thejumbo-mortgage market is showing signs of gradual improvement. However, therecan be no assurance that these trends will continue.

 

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During 2009, the California home-buyer tax credit enacted early in theyear boosted demand somewhat; however, the federal stimulus plan did notsignificantly impact sales at our Brightwater project due to its income andfirst-time buyer restrictions. As the credits expired, demand declined.  As of August 31, 2009, all of the $100million in California tax credits had been issued. On March 25, 2010, anadditional $200 million of funding was approved by the State of Californiawhich will provide up to a $10,000 credit to first-time homebuyers or thosepurchasing a newly built home starting May 1, 2010. As of August 15,2010, the Franchise Tax Board stopped accepting applications for the first-timebuyer credit and as of September 14, 2010, the Franchise Tax Boardreported that it is likely that applications for more than $100 million of thenew home credit have been received, although it is still accepting applications.

 

Our overall outlook remains cautious given the significant negativefactors and trends noted above and the uncertainty as to when our servedmarkets may experience a sustained recovery. We continue to believe a meaningful improvement in housing market conditionswill require a sustained decrease in unsold homes, price stabilization, reducedmortgage delinquency and foreclosure rates, improved economic activity andemployment levels, and the restoration of both consumer and credit marketconfidence that support a decision to buy a home. We cannot predict when theseevents may occur.  While we have begun tosee some positive signs that these negative trends in the overall economy aremoderating, it remains uncertain when the housing market or the broader economywill experience a meaningful recovery. We anticipate that the overhang ofbank-owned homes will continue to bloat the market throughout 2010 and into2011 as lenders seek to unload their inventory of foreclosed homes. We expectthat 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 remain reluctant to purchase a Brightwaterhome and we may continue 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 November 2010,the spread has narrowed to approximately .50% to .90%. 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 amortgage. Because we cannot predict the short-and long-term liquidity of thecredit markets, we continue to caution that, with the uncertainties in thesemarkets, the pace of home sales could remain depressed or slow further untilthese markets improve.

 

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

 

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

 

·                  pursued a proposed jointplan of reorganization for relief under Chapter 11 in the Bankruptcy Court inorder to restructure the approximately $182 million of Brightwater indebtednessunder the Revolving Loan and the Term Loan and to pay certain costs of exitingthe Chapter 11 process.

 

We expect to continue operations at only the four Brightwatercommunities until we see reasonable signs of a housing market recovery. Ifmarket conditions decline further, we may need to take additional charges forinventory impairments in future quarters. In addition, our results for 2010 areadversely affected by the costs of restructuring our debt through the Chapter 11Cases. 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 consumer confidence in the national economy will play amajor role in any turnaround in the homebuilding and mortgage lendingindustries. We also believe that a meaningful improvement in housing marketconditions will require the restoration of consumer and credit marketconfidence that will support a decision to buy a home, which will in turnrequire a sustained decrease in inventory levels, price stabilization andreduced foreclosure rates.

 

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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 nine months of 2010 and 2009, we delivered 14 and 39(including 21 Brightwater) homes, respectively. As of November 9, 2010,three additional homes have been delivered, bringing year-to-date deliveries to17 homes, and three additional homes are in escrow, as discussed further underItem 1—Business—Our Current and Future Homesites below.

 

Despite the challenges of the current California homebuilding market,we believe the potential for our Brightwater project remains high. Brightwaterhas not been immune to the effects of the unstable mortgage and housingmarkets; however, prior to our bankruptcy filing that impact appeared lesssevere than the weakness we have seen in our inland markets. We believe thatthe reduced impact is a result of Brightwater’s superior coastal location, theextremely limited supply of new homes on the coast of Southern California andthe absence of significant competition from other homebuilders in theHuntington Beach market due to the lack of available land for the developmentof new single family detached homes. We believe that Brightwater is in alocation that is difficult to replace and in a market where approvals areincreasingly difficult to achieve. We also believe that Brightwater hassubstantial embedded value that should not be sacrificed under currentdepressed market conditions but, rather, should be realized over time. Finally,we believe that Brightwater’s demographics remain strong due to the continuingregulation-induced constraints on lot supplies and the significant number ofaffluent households along the coast of Southern California. Therefore, weremain optimistic about continuing sales at Brightwater once we emerge frombankruptcy.

 

While we generated 31 net sales orders in the first nine months of2009, we generated only two net sales orders at Brightwater during the fourth quarterof 2009 and 10 net sales orders during the first nine months of 2010. Webelieve the deceleration in sales pace for the fourth quarter of 2009 and thefirst nine months of 2010 primarily reflects the negative impact of the Chapter11 announcement in October 2009.  Weanticipate that sales pace will continue to be negatively impacted until wesuccessfully implement a Chapter 11 plan of reorganization.

 

We expect that market conditions will continue to be challengingthroughout the remainder of 2010 and into 2011, as unemployment rates remainelevated, foreclosure activity continues to be significant and consumerconfidence continues to be eroded. Although substantially reduced home pricesand low consumer mortgage interest rates have improved housing affordability,many potential homebuyers remain tepid about purchasing a home in thisuncertain economic environment. This demand-side dynamic, in conjunction with ahigh level of foreclosures, is sustaining the oversupply of unsold new andexisting homes and competitive pricing pressures that have generated theextremely challenging conditions our industry has experienced since thebeginning 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.

 

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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 the fourth quarter of 2010 and in2011 could be adversely affected if housing, credit market, or general economicconditions deteriorate, if job losses accelerate, if consumer mortgage lendingbecomes less available or more expensive, or if consumer confidence continuesto fall, any or all of which would further diminish the prospects for arecovery in the housing market. We believe that there will not be a meaningfulimprovement in the housing market until there is a sustained decrease ininventory levels, price stabilization, reduced foreclosure rates, greateravailability of jumbo-mortgage financing, a significant improvement in jobgrowth and the restoration of consumer confidence that can support a decisionto buy a home.

 

**Our Current and Future Homesites**

 

Our homebuilding operations include active projects in the HuntingtonBeach area of Southern California.  Wedelivered 14 homes (six Trails, two Sands, five Cliffs and one Breakers) duringthe nine months ended September 30, 2010, compared with 39 deliveries (11Trails, four Sands, two Cliffs, four Breakers and 18 inland project homes)during the comparable period in 2009. We acquired no single-family residentiallots during the nine months ended September 30, 2010 and 2009 and we haveno contracts to acquire land or lots.

 

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

 
| **Project**                        | ** ** | **Location**     | ** ** | **Commenced  Sales** | ** ** | **Models  (b)** | ** ** | **Backlog** | ** ** | **Standing  Inventory** | ** ** | **Specs Under   Construction** | ** ** | **Remaining  Lots** | ** ** | **Total Lot  Inventory** | ** ** |
|------------------------------------|------------|------------------|------------|----------------------|------------|-----------------|------------|-------------|------------|-------------------------|------------|------------------------------------------|------------|---------------------|------------|-------------------------------|------------|
| Brightwater  in Orange County (a): |       |             |       |                 |       |            |       |        |       |                    |       |                                     |       |                |       |                          |       |
| The  Trails                        |       | Huntington Beach |       | 2007                 |       | 4               |       | 2           |       | 4                       |       | —                                   |       | 17                  |       | 27                            |       |
| The  Sands                         |       | Huntington Beach |       | 2007                 |       | 4               |       | 1           |       | 3                       |       | 1                                        |       | 52                  |       | 61                            |       |
| The  Cliffs                        |       | Huntington Beach |       | 2008                 |       | 4               |       | 1           |       | 1                       |       | —                                   |       | 89                  |       | 95                            |       |
| The  Breakers                      |       | Huntington Beach |       | 2008                 |       | 5               |       | 1           |       | 2                       |       | 1                                        |       | 87                  |       | 96                            |       |
| *Subtotal—Orange County*      |       |             |       |                 |       | 17              |       | 5           |       | 10                      |       | 2                                        |       | 245                 |       | 279                           |       |
| Lancaster:                         |       |             |       |                 |       |            |       |        |       |                    |       |                                     |       |                |       |                          |       |
| Unimproved  lots                   |       | Lancaster        |       | (c)                  |       | —          |       | —      |       | —                  |       | —                                   |       | 73                  |       | 73                            |       |
| *Total—All Projects*          |       |             |       |                 |       | 17              |       | 5           |       | 10                      |       | 2                                        |       | 318                 |       | 352                           |       |

 

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

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

(c)          To be determined subject tomarket conditions.

 

As of September 30, 2010, we had standing inventory of 10Brightwater homes. During the nine months ended September 30, 2010, netnew orders at Brightwater decreased to 10 homes compared with 31 homes duringthe comparable period in 2009 due to the negative impact of our Chapter 11bankruptcy on buyer confidence, the continued weak economic environment, andthe absence of sales activity at our inland projects compared with the firstnine months of 2009. During the first nine months of 2010 we had no sales ofinland homes compared with 17 (excluding the sale of 62 finished lots and fourmodel homes at the Woodhaven project) during the first nine months of 2009.Cancellations as a percentage of new orders were 33.0% during the nine monthsended September 30, 2010, compared with approximately 11.1% during thecomparable period in 2009 with the higher cancellation rate in the first ninemonths of 2010 reflecting the negative impacts of the general economy and ourcontinuing Chapter 11 bankruptcy process. Backlog for Brightwater as of September 30,2010 decreased to five homes compared with 17 homes as of September 30,2009.

 

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*Brightwater at Bolsa Chica*

 

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

 

Brightwater is the largest property in our portfolio and, along withother nearby properties (including a five-acre parcel in the process ofentitlement), comprises substantially all of our real estate inventories as of September 30,2010. This project is located on one of the last large undeveloped coastalproperties in Southern California. Brightwater is bordered on the north and eastby 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. DuringJanuary 2008, we completed construction of nine additional model homes forThe Cliffs and The Breakers and in February 2008 began selling homes tobuyers who previously registered on our priority list. We held a grand openingfor these neighborhoods in March 2008. These homes are larger than TheTrails and The Sands, ranging from 2,724 to 4,339 square feet. We begandelivering homes at The Cliffs and The Breakers during the third quarter of2008. As of September 30, 2010, we have delivered an aggregate of 77 homes(excluding the 17 model homes) at Brightwater, including 35, 17, 14, and 11homes at The Trails, The Sands, The Cliffs, and The Breakers, respectively.

 

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

 

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

 

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

 

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

 

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

 

·                  The direct costs (excludingindirect costs such as supervision, overhead, sales and marketing, warranty,insurance, etc.) of building homes at Brightwater are currently expectedto range from approximately $115 to $132 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 3% to 18%. Gross margins for thelarger homes at The Cliffs and The Breakers are currently expected toapproximate 12% to 18%, while gross margins at The Trails and The Sands arecurrently expected to approximate 3% to 10%. The decrease in expected marginsas compared with the prior quarter expectation reflects greater than expecteduse of outside brokers, particularly in the near term and incentives providedto buyers during our Chapter 11 Cases, partially offset by reduced basis due tovaluation reserves.  

 

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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 and nine months ended September 30, 2010and 2009 were as follows:

 
| ** **              | ** ** | ** **        | ** ** | **Deliveries**         | ** ** |
|-------------------------|------------|-------------------|------------|------------------------|------------|
| ** **              | ** ** | ** **        | ** ** | **Three Months**  | ** ** | **Nine Months** | ** ** |
| ** **              | ** ** | ** **        | ** ** | **Ended**              | ** ** | **Ended** | ** ** |
| ** **              | ** ** | ** **        | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **              | ** ** | **Location**      | ** ** | **2010**               | ** ** | **2009** | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **              | ** ** | ** **        | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Brightwater             |       |              |       |                   |       |   |   |   |   |   |   |
| The Trails              |       | Huntington  Beach |       | 1                      |       | 7 |   | 6 |   | 11 |   |
| The Sands               |       | Huntington  Beach |       | 1                      |       | — |   | 2 |   | 4 |   |
| The Cliffs              |       | Huntington  Beach |       | 2                      |       | — |   | 5 |   | 2 |   |
| The Breakers            |       | Huntington  Beach |       | —                 |       | — |   | 1 |   | 4 |   |
|                    |       |              |       | 4                      |       | 7 |   | 14 |   | 21 |   |
| Inland Empire/Lancaster |       |              |       |                   |       |   |   |   |   |   |   |
| Completed Projects      |       | Various           |       | —                 |       | 13 |   | — |   | 18 |   |
| * *                | * *   | * *          | * *   | * *               | * *   | * * | * * | * * | * * | * * | * * |
| * *                | * *   | * *          |       | 4                      |       | 20 |   | 14 |   | 39 |   |

 

*Huntington Beach.*  We completed construction of the first eightmodel homes for The Trails and The Sands products which range from 1,710 to2,160 square feet during July 2007 and opened for sales inAugust 2007. We completed construction of nine model homes for The Cliffsand The Breakers in January 2008 and began selling homes in February 2008.We delivered nine homes at an average price of $1.2 million, or $609 persquare foot during 2007 and 23 homes during 2008, at an average price of$1.4 million, or approximately $564 per square foot. We delivered 31 homesat an average price of $1.2 million (including three Breakers view homesaveraging $3.2 million), or approximately $539 per square foot, during the yearended December 31, 2009. During the nine months ended September 30,2010, we delivered 14 homes at an average price of $1.2 million, orapproximately $488 per square foot. We delivered three additional homes during October andearly November, including one home with wetland and ocean views, at an averageprice of $1.3 million or approximately $564 per square foot.  As of November 9, 2010, threeBrightwater homes, including no homes with wetland or ocean views, are inescrow at an average price of $1.1 million, or approximately $445 per squarefoot, and 11 additional homes are completed or under construction and have beenreleased for sale.

 

*The Trails and The Sands*

 

We delivered eight and 15 homes at The Trails and The Sands during thenine months ended September 30, 2010 and 2009, respectively, and generatedrevenue of $6.8 million and $13.2 million, respectively, and gross operatingmargins of 1.9% and 12.0%, respectively. We delivered two additional Trails andSands homes during October 2010 at an average price of $875,000. Homes atThe Trails and The Sands are presently being offered at prices ranging from$798,000 to $1.0 million. As of November 9, 2010, two homes are in escrowat The Trails and The Sands, six homes are completed and unsold, and one homeis under construction and unsold.

 

*The Cliffs and The Breakers*

 

We delivered six homes at The Cliffs and The Breakers during both thenine months ended September 30, 2010 and 2009, and generated revenue of$9.4 million and $14.5 million, respectively, and gross operating margins of12.0% and 31.2%, respectively. Three of the six homes delivered during thefirst nine months of 2009 were view homes with an average sales price of $3.2million. The decrease in margins reflects the absence of view premiums for fiveof the six homes delivered during the first nine months of 2010, expectedincreases in interest rates in connection with restructuring our debt, pricereductions and incentives required to be competitive under current marketconditions, and greater use of third-party real estate brokers. We deliveredone additional Cliffs home during early November 2010 at a price of $2.2million. Homes at The Cliffs and The Breakers are presently being offered atprices ranging from $1.3 million to $3.0 million for 2,724 to 4,339 squarefoot homes. As of November 9, 2010, one home is in escrow at The Cliffsand The Breakers, three homes are completed and unsold, and one home is underconstruction and unsold.

 

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*The Ridge*

 

We are pursuing entitlement for 22 homes averaging 3,500 square feet inthe City of Huntington Beach near our existing Brightwater project. The City ofHuntington Beach City Council approved the project on July 6, 2010.Entitlement of these lots is subject to approval by the California CoastalCommission (the “Commission”), and is currently expected to take two to threeyears.  The City of Huntington Beachsubmitted an application to the Commission during September 2010 to revisethe Local Coastal Program and we are working with the City of Huntington Beachto respond to inquiries made by the Commission staff.

 

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

 

**CriticalAccounting Policies and Estimates**

 

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

 

*Basis ofConsolidation*

 

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

 

*Impairment of Long-Lived Assets*

 

During the three and nine months ended September 30, 2010, werecorded impairment charges of $8.0 million and $14.0 million, respectively,with respect to our Brightwater project. This determination was made based uponrecent home sales activity in the marketplace and other economic data which mayor may not be representative of actual trends in the economy. Our analysis alsoconsidered less conservative assumptions which were supported by historicalanalysis of significant factors in the evaluation. Although an impairment ofthe Brightwater project has been recorded, we believe that an appropriateprojected value is particularly difficult to determine due to our extendedperiod of time in Chapter 11, which has a negative impact on potential sales ofBrightwater homes. During the comparable periods in 2009, we recorded zeroBrightwater project impairment charges and inland project impairment chargestotaling zero and $3.2 million, 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 a willingseller for such asset in a current transaction. Additionally, as appropriate,we identify alternative courses of action to recover the carrying value of ourlong-lived assets and evaluate all likely alternatives under aprobability-weighted approach as described in ASC 360-10-35.

 

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

 

We evaluated our Brightwater project for impairment as of September 30,2010, and determined that in addition to the $6.0 million impairment recordedat June 30, 2010, an additional impairment of $8.0 million was indicatedbased on our updated projection of the project’s future cash flows, includingprojected revenues, costs and gross margin, including a very slow sales periodduring the quarter ended September 30, 2010.  We based our assumptions on our evaluation ofprojected prices while reflecting current marketing efforts, review ofcompetitive home sales, characteristics of the Huntington Beach housing market,and current construction costs.  Our bookbasis in Brightwater of $219.4 million as of September 30, 2010 reflectsthe $14.0 million of impairment charges recorded during the nine months ended September 30,2010 and a fair value adjustment recorded in September 1997 under “FreshStart” accounting, as well as development and construction costs incurred andreductions for costs of sales in conjunction with real estate sales sincethen.  From 1997 through 2009, werecorded no impairment charges for Brightwater, primarily due to the longholding period and significant increases in home prices since 1997, before thecurrent challenging 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 3%-18% as of September 2010. The decrease in expected margins alsoreflects greater expected use of third-party real estate brokers, particularlyin the near-term, and incentives provided to buyers during our Chapter 11Cases, partially offset by reduced basis due to valuation reserves.  

 

Home prices and direct construction costs are two of the most criticalfactors in our impairment analysis and we estimate that a 1% change in homeprices or direct construction costs would change gross margin by approximately..75% and .25%, respectively. In addition, projected sales pace is alsocritical.  Due to their subjective andinterrelated nature, we cannot meaningfully quantify the impact of potentialchanges for all of the factors considered in our impairment analysis. Whilethere is risk that additional price reductions may be necessary, it appearsunlikely that any future price reductions or direct construction cost increaseswould result in erosion of the entire positive cash flow that we are currentlyprojecting and result in a further impairment charge for this project. However,there can be no assurance in that regard because economic and housing marketconditions may continue to worsen or other events beyond our control may occurwhich could result in a change in our assumptions.

 

In our analysis, we noted that the Brightwater project in HuntingtonBeach is in a mature housing market with very limited new home construction anda low supply of comparable resale homes with views or competitivefeatures.  Further, Huntington Beach hasconsistently outperformed other coastal Orange County cities with averagemarket times of four to six months compared with seven to eight months inneighboring coastal cities. Notably, since September 2009, supply at the$1.0 million to $1.5 million level has declined from slightly over seven monthsto slightly under seven months as of September 2010. During the same timeperiod, supply has declined from 23 months to 16 months at the $2.0 million andabove level. In January 2009, the City of Huntington Beach’s credit ratingwas raised, reflecting the city’s built-out nature and expected economicresilience of the city’s households. Therefore, market data support our assumption that our Brightwaterproject in Huntington Beach will fare better than most surrounding OrangeCounty communities and significantly better than projects in inland areas,resulting in reasonable expectations of price increases in future years as theeconomy and housing markets recover given the limited supply of new homes alongthe 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 current rates ranging from 4.75% to 5.15% and lenders continuing to acceptdown payment requirements of 20% for well-qualified buyers, down from as highas 30% for jumbo loans in the Fall of 2009. With the conforming loan maximum in Orange County continuing at$729,750, a significant portion of our potential homebuyers are able to financea substantial portion of their home purchase at historically low mortgage ratesbelow 5.0%.

 

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

 

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

 

*IncomeTaxes*

 

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

 

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

 

On October 27, 2009, we filed Chapter 11 Petitions in the BankruptcyCourt. Due to uncertainties regarding the resolution of our Chapter 11 Casesand our ability to utilize our NOLs in the future, during 2009 we recorded avaluation allowance for the remaining amount of our net deferred tax assets. Werecorded an additional valuation allowance of $8.4 million during the firstnine months of 2010 related to deferred tax assets generated during the firstnine months of the year.

 

Due to uncertainties in the estimation process, particularly withrespect to changes in facts and circumstances in future reporting periods(carryforward period assumptions), it is reasonably possible that actualresults could differ from the estimates used in our historical analyses. Ourassumptions require significant judgment because the residential homebuildingindustry is cyclical and is highly sensitive to changes in economic conditions.Our current assessment of the need for a valuation allowance is primarilydependent upon utilization of tax net operating losses in the carryforward periodand our future projected income. If our results of operations are more or lessthan projected 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 (“NOLs”)if an ownership change occurs. If we were to experience another ownershipchange, we would determine if we have an overall net unrealized built-in gain(“NUBIG”) or overall net unrealized built-in loss (“NUBIL”).  Assuming we have a NUBIG, the use of allremaining net operating losses (“NOLs”) would generally be subject to an annuallimitation equal to (i) the value of our equity immediately before theownership change, plus the increase in our value resulting from any debtcancellation through the Chapter 11 Cases, multiplied by the long-termtax-exempt rate (3.86% as of November 1, 2010) plus (ii) built-in-

 

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gains,recognized within five years of the ownership change subject to an overalllimitation of the NUBIG.  Assuming wehave a NUBIL, the use of NOLs (and other built-in losses subject to an overalllimitation of the NUBIL) would generally be subject to an annual limitationequal to our equity value before the ownership change plus the increase in ourequity value resulting from any debt cancellation through the Chapter 11 Cases,multiplied by the long-term tax-exempt rate (3.86% as of November 2010).  If our NUBIG or NUBIL is not greater than thelesser of (a) 15% of the fair market value of our assets or (b) $10million, then the NUBIG or NUBIL is deemed to be zero. 

 

We estimate that after giving effect to various transactions bystockholders who hold a 5% or greater interest in the company, we haveexperienced a three-year cumulative ownership shift of approximately 44% as of November 1,2010, as computed in accordance with Section 382. In addition, if anownership change occurs as a result of the Company’s emergence from Chapter 11,the utilization of tax net operating losses in the carryforward period islikely to be materially jeopardized.

 

On May 13, 2010, we reinstated a ban on acquisitions of additionalshares of our common stock, under certain circumstances, in order to preservethe tax benefits of our $166 million of NOLs. In accordance with provisions of our charter documents, unless we havepreviously consented in writing (i) no stockholder may acquire shares inan amount that would cause the stockholder to own 5% or more of the commonstock; and (ii) no current 5% or greater stockholder may acquire anyadditional shares of common stock.

 

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

 

*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.

 

**RecentAccounting Pronouncements**

 

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

 

**Resultsof Operations**

 

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

 

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Thefollowing tables set forth key operating and financial data for ourhomebuilding operations for the three and nine months ended September 30,2010 and 2009.

 

**Backlog as of September 30**

 
| **Homes in Backlog** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|--------------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2010**                       | ** ** | **2009**                                 | ** ** | **Change**                                                      | ** ** | **2010** | ** ** | **2009** | ** ** | **Change** | ** ** | **2010** | ** ** | **2009** | ** ** | **Change** | ** ** |
| 5                              |       | 17                                       |       | (70.6                                                           | )%         | $ | 6.5 |   | $ | 21.4 |   | (69.6 | )% | $ | 1,300 |   | $ | 1,261 |   | 3.1 | % |
|                                |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Homes Delivered****Three Months Ended September 30**

 
| **Homes Delivered** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|--------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2010**                 | ** ** | **2009**                                 | ** ** | **Change**                                                      | ** ** | **2010** | ** ** | **2009** | ** ** | **Change** | ** ** | **2010** | ** ** | **2009** | ** ** | **Change** | ** ** |
| 4                        |       | 20                                       |       | (80.0                                                           | )%         | $ | 5.6 |   | $ | 9.6 |   | (41.7 | )% | $ | 1,400 |   | $ | 480 |   | 191.7 | % |
|                          |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Homes Delivered****Nine Months Ended September 30**

 
| **Homes Delivered** | ** ** | **Value ($ in millions)** | ** ** | **Average Selling Price  ($ in thousands)** | ** ** |
|--------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------|------------|
| **2010**                 | ** ** | **2009**                                 | ** ** | **Change**                                                      | ** ** | **2010** | ** ** | **2009** | ** ** | **Change** | ** ** | **2010** | ** ** | **2009** | ** ** | **Change** | ** ** |
| 14                       |       | 39                                       |       | (64.1                                                           | )%         | $ | 16.3 |   | $ | 32.9 |   | (50.5 | )% | $ | 1,164 |   | $ | 844 |   | 37.9 | % |
|                          |            |                                          |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

We reported revenues of $5.6 million and gross operating profit before impairmentcharges of $600,000 for the third quarter of 2010, compared with$11.4 million in revenues and gross operating profit of $1.6 million forthe third quarter of 2009. Revenues in the current period reflect deliveries offour Brightwater homes. The comparable period of the prior year reflectsdeliveries of 20 homes, including seven homes at Brightwater and 13 inlandhomes.

 

Homebuilding gross operating profit before impairment charges decreased$1.0 million from $1.6 million for the third quarter of 2009 to $600,000 forthe third quarter of 2010 as a result of delivering only four homes atBrightwater which generated a 9.4% gross margin, compared with sevenBrightwater deliveries and 13 inland deliveries which generated a 16.7% grossmargin during the comparable period in 2009. The decrease in gross marginreflects expected increases in interest rates in connection with restructuringour debt, as well as sales price reductions and incentives offered in responseto the continuing difficult conditions in the housing market and greater use ofthird-party brokers.  Gross operatingprofit for the third quarter of 2010 includes an $8.0 million impairment chargerelated to our Brightwater project.

 

Reorganization costs of $2.3 million during the third quarter of 2010reflect legal and professional fees and other costs associated with the Chapter11 bankruptcy proceedings.

 

Other expense increased $200,000 in the third quarter of 2010 comparedwith the third quarter of 2009 primarily due to the accrual of $1.2 million ofremediation costs in connection with the DTSC litigation discussed above inNote 8 to our Consolidated Financial Statements. The 2009 period includedcharges for the assignment of a $700,000 receivable to a land seller who soldlots to our subsidiary, in settlement of an obligation for accrued sellerparticipation.

 

*NineMonths Ended September 30, 2010 Compared with the Nine Months Ended September 30,2009*

 

We reported revenues of $17.7 million and gross operating loss beforeimpairment charges of $3.3 million for the first nine months of 2010, comparedwith $34.7 million in revenues and gross operating profit of $4.3 million forthe first nine months of 2009. Revenues of $17.7 million in 2010 include landsale revenues of $1.4 million generated from the sale of land encumbered by anoil lease and a conservation easement. Revenues in the current period reflectdeliveries of 14 Brightwater homes (one of which was a view home). Thecomparable period of the prior year reflects deliveries of 39 homes, including21 homes at Brightwater (three of which were view homes) and 18 inland homes.

 

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Homebuilding gross operating profit before impairment charges decreased$6.2 million from $7.5 million for the first nine months of 2009 to $1.3million for the first nine months of 2010 as a result of delivering only 14homes at Brightwater which generated a 7.3% gross margin, compared with 21Brightwater deliveries and 18 inland homes which generated a 22.7% grossmargin.  Gross operating loss for thefirst nine months of 2010 includes a non-cash impairment charge of $14.0million related to our Brightwater project. Gross operating profit for thefirst nine months of 2009 includes a non-cash impairment charge of $3.2million, reflecting a fair value write-down for an inland project in Beaumontwhich was disposed of on September 30, 2009. The decrease in gross marginreflects a change in the mix of homes delivered, including seven Cliffs andBreakers homes (including one view home) among the 14 homes delivered in the2010 period compared with six Cliffs and Breakers homes (including three viewhomes) among the 21 Brightwater homes delivered during the first nine months of2009. In addition, the decrease in gross margin during the first nine months of2010 reflects expected increases in interest rates in connection withrestructuring our debt, as well as sales price reductions and incentivesoffered in response to the continuing difficult conditions in the housingmarket and greater use of third-party brokers. Gross operating profit for the first nine months of 2010 includes landsale profit of $1.4 million generated from the sale of land encumbered by anoil lease and a conservation easement.

 

Reorganization costs of $6.0 million during the first nine months of2010 reflect legal and professional fees and other costs associated with theChapter 11 bankruptcy proceedings.

 

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

 

Other expense decreased $200,000 compared with the first nine months of2009 primarily due to the absence in 2010 of a $700,000 charge related to theassignment of a receivable to a land seller who sold lots to our subsidiary, insettlement of an obligation for accrued seller participation during the 2009period as well as the absence of $600,000 of period costs related to projectswhich were no longer under construction in the 2009 period. These decreaseswere partially offset by the accrual of $1.2 million of remediation costsduring the third quarter of 2010 in connection with the DTSC litigationdiscussed above in Note 8 to our Consolidated Financial Statements.

 

*PaymentsUnder Contractual Obligations*

 

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

 

**Liquidityand Capital Resources**

 

OnSeptember 28, 2009, we received a notice of an event of default from theagent to the lending syndicate with respect to the loan-to-value covenant ofthe Revolving Loan that would give rise to the right to accelerate theindebtedness 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 ournonpayment of approximately $1.7 million of principal that was due on September 30,2009 under the terms of the Revolving Loan that would also give rise to theright to accelerate the indebtedness under the Revolving Loan and Term Loan. Asof September 30, 2010, $81.7 million and $99.8 million of principal wasoutstanding under the Revolving Loan and Term Loan, respectively.

 

The filing of the Chapter 11 Petitions on October 27, 2009, alsoconstituted events of default under the Revolving Loan and the Term Loan thatcan trigger acceleration of the indebtedness. However, the filing of the Chapter 11 Petitions automatically stayedthose actions against us and the other subsidiary Debtors.  Under the terms of Bankruptcy Court orders,we have continued to pay interest on the outstanding principal balances of theRevolving Loan and the Term Loan at agreed upon non-default interest rates. On July 28,2010, the Bankruptcy Court approved a settlement agreement between the Debtors,the agent and the existing lenders that provided, among other things, that nodefault interest will be due.  Anadditional provision which reduced the amount of legal and professional feespayable by the Debtors to the agent was nullified by the August 31, 2010expiration of Luxor’s exit financing commitment.

 

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Weare continuing to negotiate with our lenders to develop a consensual plan ofreorganization, however there can be no assurance that we will be able tosuccessfully confirm, consummate and execute a plan of reorganization withrespect to the Chapter 11 Cases in a manner that is acceptable to theBankruptcy Court and the creditors and other parties in interest.

 

While we are striving to repay the Revolving Loan and the Term Loanthrough the Chapter 11 Cases, unless we are successful in executing a plan ofreorganization in the Chapter 11 Cases, we do not believe that our cash, cashequivalents and future real estate sales proceeds will provide sufficientliquidity to meet our current debt obligations under the current terms of theexisting Revolving Loan and Term Loan Agreements, in addition to meetinganticipated operating and project development costs for Brightwater, andgeneral and administrative expenses during the next 12 months. There canalso be no assurance that a reorganization paln will be completed or that wewill emerge from the Chapter 11 bankruptcy process as presently contemplated.These factors, and others, 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):

 
| ** **                                      | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                      | ** ** | **2010**                                            | ** ** | **2009** | ** ** |
| Cash and cash equivalents                       |       | $                                                   | 3.0        |   | $ | 3.7 |   |
| Cash (used in) provided by operating activities |       | (5.9                                                | )          | 7.4 |   |
| Cash provided by investing activities           |       | —                                              |       | 0.4 |   |
| Cash used in financing activities               |       | —                                              |       | (6.4 | ) |
|                                                 |            |                                                     |            |  |  |  |  |

 

The principal assets in our portfolio are residential lots which mustbe held over an extended period of time in order to be developed to a conditionthat, in management’s opinion, will ultimately maximize our return.Consequently, we require significant capital to finance our real estate developmentand homebuilding operations. Historically, sources of capital have includedloan facilities secured by specific projects and available internal funds. Ourunrestricted cash and cash equivalents as of September 30, 2010 aggregated$3.0 million. Of this amount, the use of $1.8 million is subject to theBankruptcy Court’s interim cash collateral order and $1.2 million is held by anon-Debtor subsidiary.

 

Since the filing of the Chapter 11 Cases we have only been payinginterest under the Term and Revolving Loans as we continue to seek to obtainapproval of a plan of reorganization to replace or restructure our debt.

 

*September 30,2010 Compared with December 31, 2009*

 

Cash used in operating activities of $5.9 million for the firstnine months of 2010 primarily reflects investments in Brightwater of$17.0 million, general and administrative costs of $3.2 million andrestructuring costs of $6.0 million, which were partially offset by netproceeds from sales of $17.0 million and the increase in accounts payable andaccrued liabilities discussed below.

 

The $2.2 million increase in accounts payable and accrued liabilitiesreflects an increase of $800,000 for accrued reorganization costs and increasesin accrued amounts for interest due on the Term and Revolving Loans, otherprofessional fees and Brightwater project construction.

 

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**OffBalance Sheet Financing**

 

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

 

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

 

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 September 30,2010, we had no deposits with VIEs.

 

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

 

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

 

The long-term impact of inflation may affect us through increased costsfor land, land development, construction materials, labor and overhead, as wellas in increased sales prices of our homes. Our land acquisition costs aregenerally fixed, therefore, increases or decreases in the sales prices of homeswill affect our profits. The sales price of each of our homes is fixed at thetime a buyer enters into a contract to acquire a home. Therefore, if we sellour homes before we begin construction, any inflation of costs in excess ofthose anticipated may result in lower gross margins, unless these increasedcosts are recovered 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.

 

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

 

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

 

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

 

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

 

**Item 4.  Controls and Procedures**

 

*ConclusionRegarding the Effectiveness of Disclosure Controls and Procedures*

 

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

 

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

 

*Changesin Internal Controls*

 

Therehave been no changes in our internal control over financial reporting duringthe three months ended September 30, 2010 that have materially affected,or are reasonably likely to materially affect, our internal control overfinancial reporting.

 

**PART II - OTHER INFORMATION**

 

**Item 1.  Legal Proceedings.**

 

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

 

**Item 6.  Exhibits.**

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

 

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

 

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**SIGNATURE**

 

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

 
| Date:  November 12, 2010 | CALIFORNIA  COASTAL COMMUNITIES, INC. |
|-------------------------------|--------------------------------------------|
|                          |                                       |
|                          |                                       |   |
|                          | By:                                        | */s/  Sandra G. Sciutto* |
|                          |                                       | SANDRA  G. SCIUTTO |
|                          |                                       | Senior  Vice President and |
|                          |                                       | Chief  Financial Officer |

 

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