UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
DC 20549




FORM
10-Q




(Mark
one)


x
            QUARTERLY
      REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For
the quarterly period ended September 30, 2009





 ̈
            TRANSITION
      REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For
the transition period from         
to




Commission
File Number 33-46104-FW




THERMOENERGY
CORPORATION


(Exact
Name of Registrant as Specified in Its Charter)





Delaware
              (State
      or Other Jurisdiction of
              Incorporation
      or Organization)
            71-0659511
              (IRS
      Employer Identification No.)





124 WEST CAPITOL AVENUE, SUITE 880,LITTLE ROCK, ARKANSAS
              72201(Address of Principal Executive Offices)
              (Zip Code)


Registrant’s
Telephone Number, Including Area Code: (501) 376-6477


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




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




Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer or a smaller reporting
company.  See definitions of “large accelerated filer,” “accelerated
filer” and “smaller reporting company” in Rule 12b-2 of the Exchange
Act.





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




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




APPLICABLE
ONLY TO CORPORATE ISSUERS:




State the
number of shares outstanding of each of the issuer’s classes of common equity,
as of the latest practicable date:  53,454,293 shares of Common Stock
as of September 30, 2009.







THERMOENERGY
CORPORATON




INDEX




Page
                                  No.Part
      I.
                                
                                Financial
      InformationItem
      1.
                                
                                Financial
      Statements
                                
                                3Consolidated
      Balance Sheets as of September 30, 2009 (Unaudited) and
      December 31, 2008
                                
                                3Consolidated
      Statements of Operations for the nine months and three months ended
      September 30, 2009 and 2008  (Unaudited)
                                
                                4Consolidated
      Statements of Changes in Stockholders’ Equity (Deficit) for the year
      ended  January 1, 2008 through December 31, 2008 and the nine
      months ended September 30, 2009 (Unaudited)
                                
                                5Consolidated
      Statements of Cash Flows for the nine months ended September 30, 2009
      and 2008 (Unaudited)
                                
                                6Notes
      to Consolidated Financial Statements (Unaudited)
                                
                                7Item
      2.
                                
                                Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
                                
                                21Item
      3.
                                
                                Quantitative
      and Qualitative Disclosures About Market Risk
                                
                                23Item
      4T.
                                
                                Controls
      and Procedures
                                
                                23Part
      II.
                                
                                Other
      InformationItem
      1.
                                
                                Legal
      Proceedings
                                
                                24Item
      1a.
                                
                                Risk
      Factors
                                
                                24Item
      2.
                                
                                Unregistered
      Sales of Equity Securities and Use of Proceeds
                                
                                24Item
      3.
                                
                                Defaults
      Upon Senior Securities
                                
                                28Item
      4.
                                
                                Submission
      of Matters to a Vote of Security Holders
                                
                                28Item
      5.
                                
                                Other
      Information
                                
                                28Item
      6.
                                
                                Exhibits
                                
                                28Signature
                                
                                29




2


PART
I – FINANCIAL INFORMATION




Item
1.  Financial Statements


THERMOENERGY CORPORATION
 CONSOLIDATED
BALANCE SHEETS
 (in
thousands, except for share and par value amounts )
 
 September 30, 2009
                  
                  
                  December 31, 2008(Unaudited)ASSETSCurrent
      Assets:Cash
                  
                  $
                  743
                  
                  
                  $
                  115Accounts
      Receivable, net
                  
                  
                  12
                  
                  
                  
                  111Inventories
                  
                  
                  164
                  
                  
                  
                  164Other
      Current Assets
                  
                  
                  36
                  
                  
                  
                  164Total
      Current Assets
                  
                  
                  955
                  
                  
                  
                  554Property
      and Equipment, net
                  
                  
                  257
                  
                  
                  
                  305Other
      Assets
                  
                  
                  156
                  
                  
                  
                  176Total
      Assets
                  
                  $
                  1,368
                  
                  
                  $
                  1,035LIABILITIES
      AND STOCKHOLDERS' EQUITY (DEFICIT)Current
      Liabilities:Accounts
      Payable
                  
                  $
                  550
                  
                  
                  $
                  204Short-Term
      Borrowings
                  
                  
                  1,500
                  
                  
                  
                  873Convertible
      Debt in Default
                  
                  
                  3,708
                  
                  
                  
                  3,478Contingent
      Liability Reserves
                  
                  
                  3,154
                  
                  
                  
                  3,334Deferred
      Revenue
                  
                  
                  432
                  
                  
                  
                  264Other
      Current Liabilities
                  
                  
                  3,823
                  
                  
                  
                  2,713Total
      Current Liabilities
                  
                  
                  13,167
                  
                  
                  
                  10,866Long
      Term Liabilities:Deferred
      Comp Retirement Plan for Officers Net of Current Portion
                  
                  
                  250
                  
                  
                  
                  261Convertible
      Debt
                  
                  
                  1,300
                  
                  
                  
                  992Total
      Long Term Liabilities
                  
                  
                  1,550
                  
                  
                  
                  1,253Total
      Liabilities
                  
                  
                  14,717
                  
                  
                  
                  12,119Stockholders'
      Equity (Deficit):Preferred
      Stock, $0.01 par value, liquidation value of $1.20 per share: authorized -
      20,000,000 shares; issued and outstanding: 2009 and 2008 - 208,334
      shares
                  
                  
                  2
                  
                  
                  
                  2Common
      Stock, $.001 par value:  authorized - 150,000,000 shares;
      issued: 2009 - 53,538,090 shares; 2008 - 50,247,537 shares; outstanding:
      2009 - 53,454,293 shares; 2008 - 50,163,740 shares
                  
                  
                  54
                  
                  
                  
                  50Additional
      Paid-In Capital
                  
                  
                  64,934
                  
                  
                  
                  58,810Accumulated
      Deficit
                  
                  
                  (78,339
                  )
                  
                  
                  (68,284
                  )Total
      ThermoEnergy Corporation Stockholders' Equity (Deficit)
                  
                  
                  (13,349
                  )
                  
                  
                  (9,422
                  )Noncontrolling
      interest
                  
                  
                  
                  
                  
                  
                  (1,662
                  )Total
      Stockholders' Equity
                  
                  
                  (13,349
                  )
                  
                  
                  (11,084
                  )TOTAL
      LIABILITIES AND STOCKHOLDERS' EQUITY
                  
                  $
                  1,368
                  
                  
                  $
                  1,035
 
 See
notes to consolidated financial statements.
  3
 
 THERMOENERGY
CORPORATION
 CONSOLIDATED
STATEMENTS OF OPERATIONS
 (in
thousands, except per share amounts)
 
 Nine
      Months Ended
                  
                  
                  Three
      Months EndedSeptember 30,
                  
                  
                  September 30,2009
                  
                  
                  2008
                  
                  
                  2009
                  
                  
                  2008Contract
      and Grant Income
                  
                  $
                  2,608
                  
                  
                  $
                  1,511
                  
                  
                  $
                  970
                  
                  
                  $
                  326Less:
      Cost of Contract and Grant Income
                  
                  
                  2,926
                  
                  
                  
                  1,529
                  
                  
                  
                  1,074
                  
                  
                  
                  395Gross
      Operating Income (Loss)
                  
                  
                  (318
                  )
                  
                  
                  (18
                  )
                  
                  
                  (104
                  )
                  
                  
                  (69
                  )Operating
      Expenses:General
      and Administrative
                  
                  
                  2,940
                  
                  
                  
                  2,680
                  
                  
                  
                  1,210
                  
                  
                  
                  626Selling
      Expense
                  
                  
                  354
                  
                  
                  
                  257
                  
                  
                  
                  109
                  
                  
                  
                  102Option
      Expense
                  
                  
                  211
                  
                  
                  
                  1,469
                  
                  
                  
                  30
                  
                  
                  
                  192Warrant
      Expense
                  
                  
                  1,757
                  
                  
                  
                  1,538
                  
                  
                  
                  727
                  
                  
                  
                  839Professional
      Fees
                  
                  
                  1,210
                  
                  
                  
                  992
                  
                  
                  
                  498
                  
                  
                  
                  218Travel
      and Entertainment
                  
                  
                  257
                  
                  
                  
                  539
                  
                  
                  
                  86
                  
                  
                  
                  179Total
      Operating Expenses
                  
                  
                  6,729
                  
                  
                  
                  7,475
                  
                  
                  
                  2,660
                  
                  
                  
                  2,156Loss
      from Operations
                  
                  
                  (7,047
                  )
                  
                  
                  (7,493
                  )
                  
                  
                  (2,764
                  )
                  
                  
                  (2,225
                  )Other
      Income (Expense):Interest
      Income
                  
                  
                  -
                  
                  
                  
                  16
                  
                  
                  
                  -
                  
                  
                  
                  -Loss
      on Extinguishment of Debt
                  
                  
                  (1,208
                  )
                  
                  
                  -
                  
                  
                  
                  (1,208
                  )
                  
                  
                  -Interest
      Expense
                  
                  
                  (1,800
                  )
                  
                  
                  (946
                  )
                  
                  
                  (651
                  )
                  
                  
                  (437
                  )Total
      Other Income (Expense)
                  
                  
                  (3,008
                  )
                  
                  
                  (930
                  )
                  
                  
                  (1,859
                  )
                  
                  
                  (437
                  )Net
      loss
                  
                  
                  (10,055
                  )
                  
                  
                  (8,423
                  )
                  
                  
                  (4,623
                  )
                  
                  
                  (2,662
                  )Less:  Net
      loss attributable to noncontrolling interest
                  
                  
                  -
                  
                  
                  
                  (157
                  )
                  
                  
                  -
                  
                  
                  
                  (71
                  )Net
      Loss Attributable to ThermoEnergy Corporation
                  
                  $
                  (10,055
                  )
                  
                  $
                  (8,266
                  )
                  
                  $
                  (4,623
                  )
                  
                  $
                  (2,591
                  )Per
      Common Share Attributable to ThermoEnergy Corporation:Loss
      from Operations
                  
                  $
                  (0.13
                  )
                  
                  $
                  (0.17
                  )
                  
                  $
                  (0.05
                  )
                  
                  $
                  (0.04
                  )Net
      Loss
                  
                  $
                  (0.19
                  )
                  
                  $
                  (0.18
                  )
                  
                  $
                  (0.09
                  )
                  
                  $
                  (0.05
                  )
 
 See
notes to consolidated financial statements.
  4
 
 THERMOENERGY CORPORATION
 CONSOLIDATED
STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
 Year
Ended December 31, 2008 and the Nine Months Ended September 30, 2009
(Unaudited)
 
 ThermoEnergy Corporation Stockholders' EquitySeries A
                      Convertible
                      Preferred
                      Stock
                    
                    
                    Common
                      Stock
                    
                    
                    Additional
                      Paid-In
                      Capital
                    
                    
                    Accumulated
                      Deficit
                    
                    
                    Noncontrolling
                      Interest
                    
                    
                    Total(in
      thousands)Balance
      (Deficit) January 1, 2008
                    
                    $
                    53
                    
                    
                    $
                    40
                    
                    
                    $
                    50,794
                    
                    
                    $
                    (52,548
                    )
                    
                    $
                    (1,414
                    )
                    
                    $
                    (3,075
                    )Warrants
      issued for services
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    1,331
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    1,331Issuance
      of 220,000 shares of Common Stock for services
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    277
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    277Cashless
      exercise of 4,662,639 warrants for 1,854,984 shares of Common
      Stock
                    
                    
                    
                    
                    
                    
                    2
                    
                    
                    
                    (2
                    )
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    -Exercised
      741,493 warrants for 741,493 shares of Common Stock
                    
                    
                    
                    
                    
                    
                    1
                    
                    
                    
                    473
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    474Stock
      grants issued to officers (250,000 shares at $1.11 per
    share)
                    
                    
                    
                    
                    
                    
                    1
                    
                    
                    
                    278
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    279Stock
      options issued to officers, directors and employees
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    1,682
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    1,682Converted
      Preferred Stock to Common Stock (5,051,668 shares)
                    
                    
                    (51
                    )
                    
                    
                    5
                    
                    
                    
                    46
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    -Convertible
      Note converted to Common Stock (1,146,036 shares at $0.50 per
      share)
                    
                    
                    
                    
                    
                    
                    1
                    
                    
                    
                    572
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    573Common
      Stock Issued for interest payments (124,172 shares at $0.47 per
      share)
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    58
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    58Warrants
      and beneficial conversion feature issued with convertible
      notes
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3,301
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    3,301Net
      Loss
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (15,736
                    )
                    
                    
                    (248
                    )
                    
                    
                    (15,984
                    )Balance
      (Deficit) December 31, 2008
                    
                    $
                    2
                    
                    
                    $
                    50
                    
                    
                    $
                    58,810
                    
                    
                    $
                    (68,284
                    )
                    
                    $
                    (1,662
                    )
                    
                    $
                    (11,084
                    )Stock
      options issued to officers, directors and employees
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    584
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    584Modification
      of warrants
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    1,691
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    1,691Warrants
      issued for services
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    46
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    46Common
      Stock Issued for interest payments (313,005 shares)
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    109
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    109Issuance
      of 345,000 shares of Common Stock for services
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    188
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    188Issued
      1,428,571 shares of Common Stock for cash
                    
                    
                    
                    
                    
                    
                    2
                    
                    
                    
                    498
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    500Issued
      435,442 shares of Common Stock and warrants to acquire CASTion's
      noncontrolling interest
                    
                    
                    
                    
                    
                    
                    1
                    
                    
                    
                    268
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    269Purchase
      of CASTion shares from noncontrolling interest
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (2,282
                    )
                    
                    
                    
                    
                    
                    
                    1,662
                    
                    
                    
                    (620
                    )Warrants
      and beneficial conversion feature issued with convertible
      notes
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    4,446
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    4,446Convertible
      Note converted to Common Stock (768,535 shares at $.75 per
      share)
                    
                    
                    
                    
                    
                    
                    1
                    
                    
                    
                    576
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    577Net
      Loss
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (10,055
                    )
                    
                    
                    
                    
                    
                    
                    (10,055
                    )Balance
      (Deficit) September 30, 2009
                    
                    $
                    2
                    
                    
                    $
                    54
                    
                    
                    $
                    64,934
                    
                    
                    $
                    (78,339
                    )
                    
                    $
                    -
                    
                    
                    $
                    (13,349
                    )
 
 See
notes to consolidated financial statements.
  5
 
 THERMOENERGY
CORPORATION
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 (in
thousands)
 
 Nine
      Months EndedSeptember 30,2009
                  
                  
                  2008(Unaudited)Operating
      Activities:Net
      loss
                  
                  $
                  (10,055
                  )
                  
                  $
                  (8,423
                  )Items
      not requiring (providing) cash:Options
      issued to officers and directors
                  
                  
                  584
                  
                  
                  
                  1,469Warrant
      expense
                  
                  
                  1,757
                  
                  
                  
                  1,225Warrants
      issued for services
                  
                  
                  46
                  
                  
                  
                  -Depreciation
      expense
                  
                  
                  48
                  
                  
                  
                  31Loss
      on disposal of property and equipment
                  
                  
                  -
                  
                  
                  
                  105Loss
      on extinguishment of debt
                  
                  
                  1,208
                  
                  
                  
                  -Common
      Stock issued for services
                  
                  
                  188
                  
                  
                  
                  247Amortization
                  
                  
                  1,213
                  
                  
                  
                  595Changes
      in:Accounts
      and notes receivable
                  
                  
                  99
                  
                  
                  
                  61Inventories
                  
                  
                  -
                  
                  
                  
                  (40
                  )Other
      current assets
                  
                  
                  128
                  
                  
                  
                  71Accounts
      payable
                  
                  
                  346
                  
                  
                  
                  (818
                  )Deferred
      revenue
                  
                  
                  168
                  
                  
                  
                  (319
                  )All
      other current liabilities
                  
                  
                  1,149
                  
                  
                  
                  65Deferred
      compensation retirement plan
                  
                  
                  (11
                  )
                  
                  
                  (33
                  )Net
      cash used in operating activities
                  
                  
                  (3,132
                  )
                  
                  
                  (5,764
                  )Investing
      ActivitiesPurchases
      of property and equipment
                  
                  
                  -
                  
                  
                  
                  (114
                  )Net
      cash used by investing activities
                  
                  
                  -
                  
                  
                  
                  (114
                  )Financing
      Activities:Proceeds
      from issuance of Common Stock and warrants
                  
                  
                  500
                  
                  
                  
                  474Proceeds
      from Convertible Promissory Notes
                  
                  
                  3,260
                  
                  
                  
                  3,250Other
                  
                  
                  -
                  
                  
                  
                  (160
                  )Net
      cash provided by financing activities
                  
                  
                  3,760
                  
                  
                  
                  3,564Increase
      (Decrease) in cash
                  
                  
                  628
                  
                  
                  
                  (2,314
                  )Cash,
      beginning of year
                  
                  
                  115
                  
                  
                  
                  3,185Cash,
      end of period
                  
                  $
                  743
                  
                  
                  $
                  871
 
 See
notes to consolidated financial statements.




6




THERMOENERGY
CORPORATION




NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)





September
30, 2009




Note 1:  Basis of
presentation




In the
Notes to the Consolidated Financial Statements, we use the terms “Company”,
“we”, “our” and “us” to refer to ThermoEnergy Corporation and its
subsidiaries.  The accompanying unaudited financial statements have
been prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and Article
8-03 of Regulation S-X.  Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements.  In the opinion of management, all
adjustments (consisting of normal recurring accruals) considered necessary for a
fair presentation have been included. Operating results for the nine-month and
three-month periods ended September 30, 2009 are not necessarily indicative of
the results that may be expected for the year ended December 31,
2009.




Loss per
common share is computed by dividing the net loss for the period by the weighted
average number of shares outstanding during the period.  Stock
options, warrants, and dilutive effect of the Company’s Series A Convertible
Preferred Stock were not included in the computation of diluted loss per share
since the effect would be anti-dilutive. The adjusted weighted average number of
common shares used in the basic and diluted loss per share computations were
52,507,777 and 45,130,128 shares for the nine-month periods ended September 30,
2009 and 2008, respectively, and 53,454,293 and 49,925,292 shares for the
three-month periods ended September 30, 2009 and 2008,
respectively.




The
balance sheet at December 31, 2008 has been derived from the audited financial
statements at that date but does not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements.  As more fully discussed in Note 2, the balance
sheet at December 31, 2008 has been reclassified in connection with the adoption
of Statement of Financial Accounting Standards No. 160 “Noncontrolling Interests
in Consolidated Financial Statements, an Amendment of ARB No. 51” (“SFAS 160”)
as of January 1, 2009.




For
further information, refer to the financial statements and footnotes thereto
included in the annual report on Form 10-K for the year ended December 31, 2008
of ThermoEnergy Corporation.




Note 2:  Adoption
of SFAS 160 and purchase of CASTion Corporation noncontrolling
interest




As of
January 1, 2009, the Company implemented SFAS 160 which modifies the accounting
and disclosure requirements for subsidiaries which are not wholly-owned. In
accordance with the provisions of SFAS 160, the Company has reclassified the
noncontrolling interest previously reflected between long-term liabilities and
stockholders’ equity and included the amount as a component of stockholders’
equity in the accompanying consolidated balance sheets and consolidated
statements of stockholders’ equity. Additionally, the Company has presented the
net income attributable to the Company and the noncontrolling ownership
interests separately in the accompanying consolidated condensed statements of
operations.





On
January 5, 2009, the Company acquired substantially all of the remaining
outstanding shares of CASTion Corporation (“CASTion”). The Company issued to six
individuals and/or entities 435,442 shares of restricted Common Stock, $351,614
face amount of 10% convertible debt (conversion price of $.50 per share and a
maturity date of May 31, 2010) and warrants to acquire 424,164 shares of
restricted Common Stock. The fair value of the total consideration was $619,955.
The warrants have an exercise price of $0.50 per share and expire in
approximately 4.5 years. In addition, the Company escrowed $12,500 cash to fund
the purchase of the shares held by the remaining noncontrolling


7





THERMOENERGY
CORPORATION





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)





September
30, 2009





Note 2:  Adoption
of SFAS 160 and purchase of CASTion Corporation noncontrolling interest
(continued)





stockholders
that represent less than one percent of the acquired shares. The completion of
this transaction resulted in CASTion becoming a wholly-owned subsidiary of the
Company.





The
acquisition of the CASTion non-controlling interest was accounted for in
accordance with SFAS 160, which requires that the acquisition be recorded as an
equity transaction.  This resulted in a reduction of consolidated
additional paid-in capital of approximately $2,282,000 during the first quarter
of 2009.





Note 3:  Formation
of Babcock-Thermo Carbon Capture LLC





On
February 25, 2009, the Company’s subsidiary, ThermoEnergy Power Systems LLC,
and  Babcock Power Development, LLC (“BPD”), a subsidiary of Babcock
Power, Inc.,  entered into a Limited Liability Company Agreement (the
“LLC Agreement”) establishing Babcock-Thermo Carbon Capture LLC, a Delaware
limited liability company (the “Joint Venture”) for the purpose of developing
and commercializing our proprietary TIPS technology.





ThermoEnergy
Power Systems has entered into a license agreement with the Joint Venture and
BPD, pursuant to which it has granted to the Joint Venture an exclusive,
irrevocable (except as otherwise provided therein), world-wide, fully paid up
and royalty-free license to ThermoEnergy Power Systems’ intellectual property
related to or necessary to practice the TIPS technology (the “TIPS
License”).   In the LLC Agreement, BPD has agreed to develop, at
its own expense, intellectual property in connection with three critical
subsystems relating to the TIPS technology: a combustor subsystem, a steam
generating heating surface subsystem, and a condensing heat exchangers subsystem
(collectively, the “Subsystems”) and  BPD has entered into a license
agreement with the Joint Venture and ThermoEnergy Power Systems pursuant to
which it has granted the Joint Venture an exclusive, irrevocable (except as
otherwise provided therein), world-wide, fully paid up and royalty-free license
to BPD’s know-how and other proprietary intellectual property related to or
necessary to practice the Subsystems.




Pursuant
to the LLC Agreement, each of ThermoEnergy Power Systems and BPD owns a 50%
membership interest in the Joint Venture.  The LLC Agreement provides
that each member may be required, from time to time, to make capital
contributions to the Joint Venture to fund its operations.  The
Company made a $50,000 capital contribution in cash to the Joint Venture during
August 2009.





The Joint
Venture will be managed by a six-person Board of Managers, with three managers
appointed by each member.  The Board of Managers has adopted a set of
milestones by which it will measure the progress of the Joint
Venture.  Pursuant to the LLC Agreement, either member may withdraw
from the Joint Venture if any milestone is not met (unless the failure to meet
such milestone is primarily attributable to a failure by such member to perform
its obligations under the LLC Agreement or any related
agreements).  If a member exercises its right to withdraw, the
license that such member has granted to the Joint Venture will automatically
terminate.




The LLC
Agreement obligates the Joint Venture and each member to indemnify and hold the
other member and its affiliates harmless against damages and losses resulting
from such member’s fraud, gross negligence or intentional misconduct with
respect to the Joint Venture.  We and Babcock Power, Inc. have entered
into separate agreements to indemnify the joint venture and its members (other
than our respective subsidiary-members) and their respective affiliates against
damages and losses resulting from fraud, gross negligence or intentional
misconduct of our respective subsidiary-members with respect to the Joint
Venture.




The LLC
Agreement contains other conventional terms, including provisions relating to
governance of the entity, allocation of profits and losses, and restrictions on
transfer of a member’s interest.


8





THERMOENERGY
CORPORATION





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)





September
30, 2009





Note
4:  Short-term borrowings





Short-term
borrowings consisted of the following at September 30, 2009 and December 31,
2008 (in thousands):





2009
                  
                  
                  2008Convertible
      Promissory Note dated August  12, 2008, 7.5%, due March 31,
      2009
                  
                  $
                  -
                  
                  
                  $
                  566Convertible
      Promissory Note dated December  22, 2008, 7.5%, due June 30,
      2009, less discount of $193 in 2008
                  
                  
                  -
                  
                  
                  
                  307Secured
      Convertible Promissory Notes dated  September 28, 2009, 8%, less
      discount of $1,680 in 2009
                  
                  
                  -
                  
                  
                  
                  -Amended
      and Restated Secured Convertible Promissory Notes, 8%, less discount of
      $2,500 in 2009
                  
                  
                  1,500
                  
                  
                  
                  -$
                  1,500
                  
                  
                  $
                  873





The
Convertible Promissory Note dated August 12, 2008 maturing on March 31, 2009 was
converted to 768,535 shares of the Company’s Common Stock on April 1,
2009.





The
Convertible Promissory Note (principal amount of $500,000) dated December 22,
2008 remained outstanding after June 30, 2009 and was amended and restated on
September 28, 2009 in connection with the Series B Convertible Preferred Stock
financing contemplated by a term sheet dated September 16, 2009 between the
Company and an investor group, as more fully discussed below.





On
February 11, 2009, the Company issued to the Quercus Trust (“Quercus”) a 10%
Secured Convertible Promissory Note in the principal amount of $250,000, which
was amended and restated on September 28, 2009 in connection with the Series B
Convertible Preferred Stock financing contemplated by a term sheet dated
September 16, 2009 between the Company and an investor group, as more fully
discussed below.





On April
27, 2009, the Company issued to three different funds and two individual
affiliates of Empire Capital Partners 10% Convertible Promissory Notes
aggregating $500,000 in principal amount.  The Company also issued
warrants to acquire 2,500,000 shares of Common Stock to the holders of the
Notes.  The warrants had an exercise price of $0.55 (which was reduced
to $.50 as more fully discussed below) and an expiration date of five years from
the grant date.  The Company estimated the fair value of the warrants
issued using a Black-Scholes option pricing model and allocated $349,000 of the
proceeds received to the warrants on a relative fair value basis.  In
addition a beneficial conversion feature amounting to $151,000 was recorded
resulting in a total debt discount of $500,000, which was amortized to interest
expense.  The Notes were amended and restated on September 28, 2009 in
connection with the Series B Convertible Preferred Stock financing contemplated
by a term sheet dated September 16, 2009 between the Company and an investor
group, as more fully discussed below.


9





THERMOENERGY
CORPORATION





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)





September
30, 2009





Note 4: Short-term
borrowings (continued)




On June
25, 2009, the Company issued to Quercus a 10% Secured Convertible Promissory
Note.  Under the terms of the Note, Quercus agreed to make advances to
the Company, from time to time, up to an aggregate principal amount of $150,000.
We also entered into a letter agreement with Quercus in which we acknowledged
that certain conditions to Quercus’ obligation to invest an additional
$5,000,000 in the Company pursuant to the September 15, 2008 Securities Purchase
Agreement had not been and cannot be met, and we irrevocably released any claim
we may have on Quercus to make any further investment.  The Note was
amended and restated on September 28, 2009 in connection with the Series B
Convertible Preferred Stock financing contemplated by a term sheet dated
September 16, 2009 between the Company and an investor group, as more fully
discussed below.





On June
26, 2009, the Company issued to the Focus Fund, L.P. (“Focus Fund”) a 10%
Convertible Promissory Note due October 15, 2009 in the principal amount of
$108,000.  In connection with the Note, we also issued a warrant to
The Focus Fund to purchase 600,000 shares of the Company’s Common Stock on or
before June 17, 2014 at an exercise price of $.54 (which was reduced to $.50 as
more fully discussed below) per share.  The Company estimated the fair
value of the warrant issued using a Black-Scholes option pricing model and
allocated $46,000 of the proceeds received to the warrant on a relative fair
value basis. In addition, a beneficial conversion feature amounting to $19,000
was recorded resulting in a total debt discount of $65,000 which was amortized
to interest expense.  On July 31, 2009, the outstanding principal
balance of the Note was rolled into the convertible debt security described in
the next paragraph.





On July
31, 2009, the Company issued an 8% Secured Convertible Promissory Note in the
principal amount of $600,000 to the Focus Fund. The Note was due on the earlier
to occur of (i) the closing of an equity or convertible debt investment yielding
gross proceeds to the Company of not less than $2,000,000 or (ii) December 31,
2011. The Note was convertible into Common Stock of the Company at the option of
the holder at a price of $.30 per share and was secured by the Company’s 85%
ownership interest in ThermoEnergy Power Systems. In addition, the Company
issued a warrant to the Focus Fund L.P. for the purchase of 2,400,000 shares of
the Company’s Common Stock at a price of $.50 per share. The warrant expires on
July 31, 2014.  The Company estimated the fair value of the warrant
issued using a Black-Scholes option pricing model and allocated $246,000 of the
proceeds received to the warrant on a relative fair value basis. In addition, a
beneficial conversion feature amounting to $266,000 was recorded resulting in a
total debt discount of $512,000.





On August
21, 2009, the Company received a short-term loan in the amount of $110,000 from
the Focus Fund.  This loan was repaid in September 2009.





On
September 16, 2009, the Company and an investor group, consisting of Quercus,
Empire Capital Partners, Robert S. Trump and the Focus Fund, signed a term sheet
for a Series B Convertible Preferred Stock financing, which if fully funded,
would result in cash proceeds of $6,250,000 to the Company. The term sheet
provides for funding in four tranches, with the first and second tranche amounts
totaling $3,050,000 based on specified time periods and the third and fourth
tranche amounts totaling $3,200,000 based on the occurrence of specified
events.


10





THERMOENERGY
CORPORATION





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)





September
30, 2009





Note 4: Short-term
borrowings (continued)





In the
first tranche funding of $1,680,000, the Company issued 8% Secured Convertible
Promissory Notes on September 28, 2009 identical in form and substance to the
Company’s 8% Secured Convertible Promissory Note issued to the Focus Fund on
July 31, 2009 in the principal amount of $600,000, which was amended to provide
for a conversion price of $.24 per share instead of $.30 per share and a
maturity date of December 31, 2010. In addition, the Company’s outstanding
Convertible Promissory Notes payable to the investors in the original aggregate
principal amount of $3,400,000, including the Note issued to Quercus on
September 15, 2008 in the original principal amount of $2,000,000 which was
classified in long-term liabilities prior to September 28, 2009 since the
original maturity date of the Note was September 30, 2013 (see Note 6), were
amended and restated to conform to the same terms as the 8% Secured Convertible
Promissory Notes. The security for all of the 8% Secured Convertible Promissory
Notes is the Company’s 85% interest in ThermoEnergy Power Systems.





In
connection with the first tranche funding discussed in the preceding paragraph,
the Company also issued warrants to acquire 6,720,000 shares of Common Stock to
the holders of the Notes.  The warrants have an exercise price of
$0.50 and expire five years from the grant date.  The Company
estimated the fair value of the warrants issued using a Black-Scholes option
pricing model and allocated $815,000 of the proceeds received to the warrants on
a relative fair value basis. In addition, the difference between the effective
conversion price of the Notes and the fair value of the Company’s Common Stock
on the date of issuance of the Notes resulted in a beneficial conversion feature
amounting to $865,000, the intrinsic value of the conversion feature on that
date. The total debt discount of $1,680,000 is amortized to interest expense
over the stated term of the Notes.





Management
determined that the amended and restated note transactions discussed above,
aggregating $4,000,000 in outstanding principal amount, were exchanges of debt
instruments with substantially different terms requiring debt extinguishment
accounting.  A portion of the reacquisition price was allocated to the
beneficial conversion options associated with the original debt based on the
options’ intrinsic values at the extinguishment date, which resulted in a
reduction of $762,000 in additional paid-in capital.  The loss on
extinguishment of debt amounted to $1,208,394.  The intrinsic value of
the amended and restated Notes was $2,500,000, which was recorded as debt
discount and is amortized to interest expense over the stated terms of the
Notes.





In the
second tranche funding of $1,400,000, expected to occur on or before November
16, 2009, the Company will issue shares of Series B Convertible Preferred Stock
at a price per share to be specified at that date. Upon the closing of the
second tranche funding, the outstanding principal and accrued interest on all of
the 8% Secured Convertible Promissory Notes will convert automatically into
shares of the Company’s Series B Convertible Preferred Stock at the price per
share at which such Preferred Stock will be issued. Each share of Series B
Convertible Preferred Stock will be convertible, at any time at the discretion
of the holder, into ten shares of the Company’s Common Stock. Except with
respect to the election of the Board of Directors, holders of Series B
Convertible Preferred Stock will vote on an as-converted basis together with the
Common Stock holders on all matters. The term sheet provides that the Company’s
Board of Directors will consist of seven members. Four Directors will be elected
by holders of the Company’s Series B Convertible Preferred Stock (three to be
designated by Quercus and one by Robert S. Trump) and three Directors will be
elected by the holders of the Company’s Common Stock.





If the
events specified in the agreement occur, in the third tranche funding of
$1,800,000 and the fourth tranche funding of $1,400,000, the Company will issue
shares of Series B Convertible Preferred Stock.  Common Stock warrants
with an aggregate exercise price equal to 200% of the principal amount invested
will be issued to the investors at the closing of each tranche. The warrants
will expire in five years and provide for an exercise price of $.50 per
share.


11





THERMOENERGY
CORPORATION





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)





September
30, 2009





Note 4: Short-term
borrowings (continued)





The term
sheet also provides, among other things, for the following: (i) the reduction of
the exercise price to $.50 for the Company’s outstanding warrants held by the
investors which have an exercise price greater than $.50 and were issued in
conjunction with convertible notes which were amended in accordance with the
term sheet (see Note 7); (ii) the dismissal of the litigation filed by Quercus
against the Company; (iii) the execution by the Company and theinvestors of
mutual general releases of all prior claims (whether or not yet asserted); (iv)
the removal of the registration payment arrangements with Quercus; (v) the
employment of a new Chief Executive Officer and Chief Financial Officer; and
(vi) the termination of all existing employment agreements with the Company’s
executive officers.





Note 5: Convertible debt in
default





For the
nine months ended September 30, 2009, amortization of debt discount on the
convertible debt in default amounted to approximately $104,000.  At
September 30, 2009, the total debt discount on the convertible debt in default
was $208,869.  In accordance with the Note agreements, accrued
interest of $126,000 was added to the outstanding principal balances (which
aggregated $3,916,933 at September 30, 2009) of the convertible debt during
2009.  The maturity date of the convertible debt is May 31,
2010.





Note 6: Convertible
debt





Convertible
debt consisted of the following at September 30, 2009 and December 31, 2008 (in
thousands):





2009
                    
                    
                    2008Convertible
      Promissory Note dated March  21, 2007, 5%, due March 21, 2013,
      less discounts of $191 in 2009 and $221 in 2008
                    
                    $
                    660
                    
                    
                    $
                    588Convertible
      Promissory Note dated March 7, 2008, 5%, due March 7, 2013, less discounts
      of $529 in 2009 and $628 in 2008
                    
                    
                    280
                    
                    
                    
                    141Convertible
      Promissory Note dated September 15, 2008, 10%, due September 30, 2013,
      less discount of $1,737 in 2008
                    
                    
                    -
                    
                    
                    
                    263Convertible
      Promissory Notes dated January 5,2009, 10%, due May 31,
    2010
                    
                    
                    360
                    
                    
                    
                    -$
                    1,300
                    
                    
                    $
                    992





In
accordance with the terms of the Notes, the Company added approximately $40,000
of accrued interest to each of the outstanding principal balances of the 5%
Convertible Promissory Notes during 2009.


12





THERMOENERGY
CORPORATION





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)





September
30, 2009





Note 6: Convertible debt
(continued)





The
Convertible Promissory Note dated September 15, 2008 (original principal balance
of $2,000,000) was amended and restated on September 28, 2009 in connection with
the Series B Convertible Preferred Stock financing contemplated by a term sheet
dated September 16, 2009 between the Company and an investor group (see Note
4).





As more
fully discussed in Note 2, on January 1, 2009 the Company issued $352,000 face
amount of 10% Convertible Promissory Notes in connection with the acquisition of
the remaining noncontrolling interest of CASTion.  The Notes are
convertible by the holder into the Company’s Common Stock at $.50 per
share.  As of September 30, 2009, the Company had added $8,000 of
accrued interest to the outstanding principal balances of the
Notes.





Note 7:  Common
Stock





As
discussed more fully in Note 2, the Company issued 435,442 shares of Common
Stock in connection with the acquisition of the remaining noncontrolling
interest of CASTion.





On
February 26, 2009, the Company awarded various officers a total of 1,000,000
non-qualified stock options.  The options are exercisable at $1.50 per
share which was approximately 325% of the closing market price on the date of
issue, and expire in ten years from the date of award.  Since the
options were granted as bonuses for 2008, an accrued bonus of $306,400, the fair
value of the options on the date of grant using the Black-Scholes option model,
was included in Other Current Liabilities in the 2008 Consolidated Balance
Sheet.  On the grant date of February 26, 2009, additional paid-in
capital was increased by $306,400 in satisfaction of the outstanding liability
for the bonus.





On March
6, 2009, the Company issued and sold 1,428,571 shares of Common Stock for cash
at $.35 per share and issued warrants to acquire 714,286 shares of Common Stock
to an unrelated third party institutional investor.  The warrants have
an exercise price of $0.525 and expire five years from the grant
date.  Pursuant to the warrant agreements, we reduced the exercise
price of the Quercus warrants for 14,000,000 shares of the Company’s Common
Stock from $1.25 to $.525 per share due to the March 6, 2009 sale of Common
Stock at $0.35 per share.  The warrant modification resulted in the
recording of $1,030,000 of warrant expense in the first quarter of
2009.





As
discussed in Note 4, the Convertible Promissory Note dated August 12, 2008
maturing on March 31, 2009 was converted to 768,535 shares of the Company’s
Common Stock at $.75 per share on April 1, 2009.  During the nine
months ended September 30, 2009, the Company issued 345,000 shares of Common
Stock for services and 313,005 shares of Common Stock in satisfaction of accrued
interest on convertible debt.





In
connection with the reduction of the exercise price of certain of the Company’s
outstanding warrants described in Note 4, the Company recorded option expense of
$497,000 during the third quarter of 2009, including $475,000 due to the
reduction of the exercise price from $.525 to $.36 per share for 14,000,000
shares of the Company’s Common Stock pursuant to the Quercus warrant
agreements.





On
September 16, 2009, the Company’s Board of Directors approved the following
transactions:  (i) the issuance to an officer of the Company of a
10-year warrant for 600,000 shares of the Company’s Common Stock at an exercise
price of $.24 per share in exchange for the surrender of stock options for
600,000 shares of the Company’s Common Stock issued to the officer in 2007; (ii)
the issuance of 10-year warrants to two members of the Company’s Board of
Directors for a total of 80,000 shares at an exercise price of $.31; and (iii)
the extension of the exercise period for stock options that had been previously
issued to two members of the Company’s Board of Directors.  In
connection with these transactions, the Company recorded warrant expense of
$164,000 and option expense of $30,000 during the third quarter of
2009.


13





THERMOENERGY
CORPORATION





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)





September
30, 2009





Note 8:
Segments





The Water
Group segment represents revenue and costs related to the development and
commercialization of patented water treatment technologies and includes our
headquarters and related operations. The Power Group segment represents revenue
and costs related to the development and commercialization of patented clean
energy technologies.  The Water Group segment allocates support costs
to the Energy Group segment on a percentage basis. The Company’s operations are
currently conducted in the United States.





For
      the nine months ended September 30, 2009(in
      thousands)Water
      Group
                              
                              
                              Power
                                Group
                              
                              
                              TotalOperating
      income:Sales
      of wastewater treatment and recovery systems
                              
                              $
                              2,394
                              
                              
                              $
                              -
                              
                              
                              $
                              2,394Grant
      revenue
                              
                              
                              -
                              
                              
                              
                              214
                              
                              
                              
                              214Total
      operating income
                              
                              
                              2,394
                              
                              
                              
                              214
                              
                              
                              
                              2,608Operating
      expenses:Cost
      of wastewater treatment and recovery systems sales
                              
                              
                              2,708
                              
                              
                              
                              218
                              
                              
                              
                              2,926General
      and administrative
                              
                              
                              4,407
                              
                              
                              
                              -
                              
                              
                              
                              4,407Selling
      expenses
                              
                              
                              354
                              
                              
                              
                              -
                              
                              
                              
                              354Total
      operating expenses
                              
                              
                              7,469
                              
                              
                              
                              218
                              
                              
                              
                              7,687-Segment
      operating loss
                              
                              $
                              (5,075
                              )
                              
                              $
                              (4
                              )
                              
                              $
                              (5,079
                              )Total
      assets
                              
                              $
                              1,368
                              
                              
                              $
                              -
                              
                              
                              $
                              1,368Reconciliation
      to net loss:Total
      segment operating loss
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              $
                              (5,079
                              )Warrants
      and stock options
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              (1,968
                              )Other
      income (expense)
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              (3,008
                              )Net
      loss attributable to ThermoEnergy Corporation
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              $
                              (10,055
                              )


14





THERMOENERGY
CORPORATION





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)





September
30, 2009





Note 8: Segments
(continued)





For
      the nine months ended September 30, 2008(in
      thousands)Water
      Group
                              
                              
                              PowerGroup
                              
                              
                              TotalOperating
      income:Sales
      of wastewater treatment and recovery systems
                              
                              $
                              1,085
                              
                              
                              $
                              -
                              
                              
                              $
                              1,085Grant
      revenue
                              
                              
                              -
                              
                              
                              
                              426
                              
                              
                              
                              426Total
      operating income
                              
                              
                              1,085
                              
                              
                              
                              426
                              
                              
                              
                              1,511Operating
      expenses:Cost
      of wastewater treatment and recovery systems sales
                              
                              
                              1,446
                              
                              
                              
                              83
                              
                              
                              
                              1,529General
      and administrative
                              
                              
                              3,868
                              
                              
                              
                              343
                              
                              
                              
                              4,211Selling
      expenses
                              
                              
                              257
                              
                              
                              
                              -
                              
                              
                              
                              257Total
      operating expenses
                              
                              
                              5,571
                              
                              
                              
                              426
                              
                              
                              
                              5,997-Segment
      operating loss
                              
                              $
                              (4,486
                              )
                              
                              $
                              -
                              
                              
                              $
                              (4,486
                              )Total
      assets
                              
                              $
                              1,927
                              
                              
                              $
                              -
                              
                              
                              $
                              1,927Reconciliation
      to net loss:Total
      segment operating loss
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              $
                              (4,486
                              )Warrants
      and stock options
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              (3,007
                              )Other
      income (expense)
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              (930
                              )Net
      loss attributable to noncontrolling interest
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              157Net
      loss attributable to ThermoEnergy Corporation
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              $
                              (8,266
                              )




15





THERMOENERGY
CORPORATION





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)





September
30, 2009





Note 8: Segments
(continued)





For
      the three months ended September 30, 2009(in
      thousands)Water
      Group
                              
                              
                              Power
                                Group
                              
                              
                              TotalOperating
      income:Sales
      of wastewater treatment and recovery systems
                              
                              $
                              970
                              
                              
                              $
                              -
                              
                              
                              $
                              970Grant
      revenue
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -Total
      operating income
                              
                              
                              970
                              
                              
                              
                              -
                              
                              
                              
                              970Operating
      expenses:Cost
      of wastewater treatment and recovery systems sales
                              
                              
                              1,074
                              
                              
                              
                              -
                              
                              
                              
                              1,074General
      and administrative
                              
                              
                              1,794
                              
                              
                              
                              -
                              
                              
                              
                              1,794Selling
      expenses
                              
                              
                              109
                              
                              
                              
                              -
                              
                              
                              
                              109Total
      operating expenses
                              
                              
                              2,977
                              
                              
                              
                              -
                              
                              
                              
                              2,977-Segment
      operating loss
                              
                              $
                              (2,007
                              )
                              
                              $
                              -
                              
                              
                              $
                              (2,007
                              )Total
      assets
                              
                              $
                              1,368
                              
                              
                              $
                              -
                              
                              
                              $
                              1,368Reconciliation
      to net loss:Total
      segment operating loss
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              $
                              (2,007
                              )Warrants
      and stock options
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              (757
                              )Other
      income (expense)
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              (1,859
                              )Net
      loss attributable to ThermoEnergy Corporation
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              $
                              (4,623
                              )


16





THERMOENERGY
CORPORATION





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)





September
30, 2009





Note 8: Segments
(continued)





For
      the three months ended September 30, 2008(in
      thousands)Water
      Group
                              
                              
                              PowerGroup
                              
                              
                              TotalOperating
      income:Sales
      of wastewater treatment and recovery systems
                              
                              $
                              183
                              
                              
                              $
                              -
                              
                              
                              $
                              183Grant
      revenue
                              
                              
                              -
                              
                              
                              
                              143
                              
                              
                              
                              143Total
      operating income
                              
                              
                              183
                              
                              
                              
                              143
                              
                              
                              
                              326Operating
      expenses:Cost
      of wastewater treatment and recovery systems sales
                              
                              
                              377
                              
                              
                              
                              18
                              
                              
                              
                              395General
      and administrative
                              
                              
                              898
                              
                              
                              
                              125
                              
                              
                              
                              1,023Selling
      expenses
                              
                              
                              102
                              
                              
                              
                              -
                              
                              
                              
                              102Total
      operating expenses
                              
                              
                              1,377
                              
                              
                              
                              143
                              
                              
                              
                              1,520-Segment
      operating loss
                              
                              $
                              (1,194
                              )
                              
                              $
                              -
                              
                              
                              $
                              (1,194
                              )Total
      assets
                              
                              $
                              1,927
                              
                              
                              $
                              -
                              
                              
                              $
                              1,927Reconciliation
      to net loss:Total
      segment operating loss
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              $
                              (1,194
                              )Warrants
      and stock options
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              (1,031
                              )Other
      income (expense)
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              (437
                              )Net
      loss attributable to noncontrolling interest
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              71Net
      loss attributable to ThermoEnergy Corporation
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              $
                              (2,591
                              )


17





THERMOENERGY
CORPORATION





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)





September
30, 2009




Note
9:  Management’s consideration of going concern
matters




The
Company has incurred net losses since inception and will require substantial
additional capital to continue commercialization of the Technologies and to fund
the Company’s liabilities, which included approximately $2,442,000 of payroll
tax liabilities (see Note 10), $3,708,000 of convertible debt securities in
default, net of debt discounts aggregating $209,000 and $3,154,000 of contingent
liability reserves (see Note 10).  In addition, the Company may be
subject to tax liens if it cannot satisfactorily settle the outstanding payroll
tax liabilities and may also face criminal and/or civil action with respect to
the impact of the payroll tax matters (see Note 10).  The financial
statements have been prepared assuming the Company will continue as a going
concern, realizing assets and liquidating liabilities in the ordinary course of
business and do not reflect any adjustments that might result from the outcome
of the aforementioned uncertainties. Management is considering several
alternatives for mitigating these conditions.





Management
has determined that obtaining substantial additional funding is essential to its
continued existence.  Management actively engaged in negotiations with
a group of investors that had provided funding to the Company in the
past.  As more fully described in Note 4, the Company and the investor
group approved a term sheet on September 16, 2009 for a Series B Convertible
Preferred Stock financing that, if fully funded, would result in cash proceeds
to the Company of $6,250,000. The financing provides for funding in four
tranches, with the first and second tranche amounts totaling $3,050,000 based on
specified time periods and the third and fourth tranche amounts totaling
$3,200,000 based on the occurrence of specified events. The first tranche
Secured Convertible Promissory Notes with an aggregate principal balance of
$1,680,000 were issued on September 28, 2009.





Management
is also actively pursuing commercial contracts to produce fees from projects
involving the Technologies.  Management has determined that the
financial success of the Company may be largely dependent upon the ability and
financial resources of established third parties collaborating with the Company
with respect to projects involving the Technologies.  As discussed
more fully in Note 3, on February 25, 2009, ThermoEnergy Power Systems and
Babcock Power Development, LLC, a subsidiary of Babcock Power, Inc., entered
into a Limited Liability Company Agreement establishing Babcock-Thermo Carbon
Capture, LLC, a Delaware limited liability company for the purpose of developing
and commercializing our TIPS technology.





Note 10: Commitments and
contingencies





On June
2, 2009, the Company’s Audit Committee engaged special counsel to conduct an
in-depth investigation of the federal and state employment and unemployment tax
return filing and tax paying compliance record of the
Company.  Questions concerning payroll tax matters arose during the
preparation of the Company’s consolidated financial statements for the year
ended December 31, 2008 and the Company’s Chief Financial Officer could not
produce reliable documentation supporting the Company’s status with respect to
compliance with the tax return filing and tax paying
requirements.  After discovering that no payroll tax returns had been
filed and that no payroll taxes had been paid to the Internal Revenue Service
and state taxing authorities since the CFO assumed office in mid-2005, the
special counsel’s investigation was expanded to include a forensic accounting
review of the Company’s financial records by a certified public accounting firm
not involved with the audit of the Company’s financial statements.





On July
30, 2009, the special counsel presented a report to the Company’s Audit
Committee which summarized the findings of the investigation, including the
forensic accounting review.  The report confirmed that the Company had
not filed any payroll tax returns or paid any payroll taxes since mid-2005 and
that the Company’s CFO had sole responsibility for performing those
functions.  A computation of the outstanding payroll tax liabilities
and of statutory interest and penalties relating to the nonpayment of the
payroll taxes and the nonfiling of the payroll tax returns was included in the
report.


18





THERMOENERGY
CORPORATION





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)





September
30, 2009





Note 10: Commitments and
contingencies (continued)





On July
31, 2009, the Company’s Board of Directors unanimously approved a resolution
that the CFO’s employment be terminated for cause.  The CFO resigned
on August 3, 2009.





During
the fourth quarter of 2008, the Company accrued additional payroll taxes of
approximately $1,064,000 resulting in total unpaid payroll taxes of
approximately $2,022,000 at December 31, 2008, and recorded a contingency
accrual of approximately $2,105,000 for estimated interest and penalties for
late filing of the payroll tax returns and nonpayment of the payroll
taxes.  Unpaid payroll taxes and the contingency accrual for estimated
penalties and interest thereon as of September 30, 2009 amounted to
approximately $2,442,000 and $2,200,000, respectively.  Management
plans to file the payroll tax returns as soon as possible and to present an
offer in compromise for settlement of the payroll tax liabilities to the tax
authorities, which would require a minimum cash payment of approximately
$400,000 with the offer.  The Company cannot predict the outcome of
the offer in compromise proceedings.





The
Company may become subject to tax liens if it cannot satisfactorily settle the
outstanding payroll tax liabilities.  Furthermore, due to the actions
of the CFO summarized above, the Company may also face criminal and/or civil
action with respect to the payroll tax matters.  The Company cannot
predict what, if any, actions may be taken by the tax authorities or other
parties or the effect the actions may have on the Company’s results of
operations, financial condition or cash flows.





On April
6, 2009, the Company received a Complaint filed by David Gelbaum, as Trustee of
Quercus, bringing action against the Company in Delaware (the “Delaware
Complaint”) to enforce the provisions of the Securities Purchase Agreement
between Quercus and the Company dated December 18, 2007.  The
complaint requested enforcement of the Agreement of the shelf registration of
the underlying securities and the payment of liquidation damages for the failure
to register the securities.  On April 13, 2009, the Company received a
letter from Counsel of Quercus notifying the acceleration and a demand for
payment of the 10% Convertible Promissory Note due September 30, 2013 in the
principal amount of $2,000,000.  The letter claims events of default
defined in the Note.    On April 29, 2009, Quercus brought
an action in the United States District Court for the Eastern District of
Arkansas against the Company (the “Arkansas Complaint’) to enforce the
provisions of the 2008 Agreement for the $2,000,000 Convertible Note. The
Arkansas Complaint alleged that, as a result of the events of default, the Note
was due and payable and sought judgment in the amount of the Note (plus costs of
collection).  The Arkansas Complaint also alleged that we have
breached our shelf registration obligation with respect to the shares of our
Common Stock issuable upon conversion of the Note or upon exercise of the
warrant issued to Quercus pursuant to the 2008 Agreement and sought liquidated
damages for the failure to register such shares.





On
September 28, 2009, the Arkansas Complaint was dismissed.  On
September 30, 2009, the Delaware Complaint was dismissed.


19





THERMOENERGY
CORPORATION





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)





September
30, 2009





Note 10: Commitments and
contingencies (continued)





The
Company’s contingent liability reserves consisted of the following at September
30, 2009 and December 31, 2008 (in thousands):





2009
                  
                  
                  2008Estimated
      penalties and interest – payroll tax liabilities
                  
                  $
                  2,200
                  
                  
                  $
                  2,105Other,
      including unasserted claims
                  
                  
                  954
                  
                  
                  
                  1,229$
                  3,154
                  
                  
                  $
                  3,334





Note
11:  Subsequent events





On
November 2, 2009, the Board of Directors awarded a stock option to a newly -
appointed officer of the Company for the purchase of 2,500,000 shares of
Common Stock with an exercise price of $0.32 per share with a provision for net
surrender cashless exercise.   The option has a term of ten
years, subject to the officer’s continued employment with us, and vests with
respect to the first 625,000 shares on September 30, 2010 and thereafter in
quarterly installments of 156,250 shares each through September 30, 2013;
provided, however, that if prior to September 30, 2010, a change of control (as
such term is defined in the officer’s employment agreement) occurs, the option
will immediately vest with respect to 635,000 shares.




On November
13, 2009, the Company’s Board of Directors approved a resolution to amend the
Company’s Certificate of Incorporation to increase to 300,000,000 the number of
shares of Common Stock that the Company is authorized to issue.  The
amendment is subject to approval by the Company’s stockholders.


20





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





The
following discussion should be read in conjunction with the financial statements
and notes thereto appearing elsewhere in this report.




Overview





Currently
the Company is primarily a “water company” with patented and proprietary water
technologies that reside in the Company’s water subsidiary,
CASTion.  The water technologies address wastewater problems for
municipal and a broad range of industrial markets including water management and
conservation, chemical recovery, and water purification.  The
Company’s advanced power plant technology, TIPS, is aimed at competing with and
ultimately replacing conventional energy fossil fuel combustion technologies for
both large stationary utility power plants and small industrial combined heat
and power package plants. The Company has developed TIPS mostly from funding
from federal grants, and recently completed the approximately $1.5 million
federal government grant sponsored by the U.S. Environmental Protection Agency
and administered through the Alaska Energy Authority.  The Company
cannot predict the acceptability of TIPS within its target
markets.  The Company currently does not possess the technical,
operational or financial resources necessary to construct or operate TIPS
commercial facilities without external project funding and the ability to source
engineering skills.This was a major factor
in the Company’s subsidiary, ThermoEnergy Power System, LLC,
and  Babcock Power Development, LLC, a subsidiary of Babcock Power,
Inc.,  entering into a Limited Liability Company Agreement on February
25, 2009 establishing Babcock-Thermo Carbon Capture LLC, a Delaware limited
liability company for the purpose of developing and commercializing TIPS (see
Note 3 of Notes to Consolidated Financial Statements).





Recent
events have had a significant adverse effect on the Company’s liquidity and
results of operations.  As more fully discussed in Note 10 of Notes to
Consolidated Financial Statements, in 2009, the Company discovered that the
former Chief Financial Officer (“CFO”) failed to file the Company’s payroll tax
returns and to pay the related payroll taxes since he assumed his officer
position in 2005.  This resulted in an accrual during the fourth
quarter of 2008 of an additional $1,064,000 of payroll taxes and $2,105,000 of
estimated interest and penalties for late filing of the tax returns and
nonpayment of the payroll taxes.  The Company’s investigation into the
actions regarding payroll taxes and other activities of the former CFO resulted
in significant delays in the Company being able to file the Annual Report on
Form 10-K for the year ended December 31, 2008 (which was filed on October 8,
2009) and the Company’s Form 10-Q reports for the quarters ended March 31, 2009
and June 30, 2009 (which were filed on October 15, 2009).





Management
has determined that obtaining substantial additional funding is essential to its
continued existence.  Management actively engaged in negotiations with
a group of investors that had provided funding to the Company in the
past.  As more fully described in Note 4 of Notes to the Consolidated
Financial Statements, the Company and the investor group approved a term sheet
on September 16, 2009 for a Series B Convertible Preferred Stock financing that,
if fully funded, would result in cash proceeds to the Company of
$6,250,000.  The financing provides for funding in four tranches, with
the first and second tranche amounts totaling $3,050,000 based on specified time
periods and the third and fourth tranche amounts totaling $3,200,000 based on
the occurrence of specified events.  The first tranche Secured
Convertible Promissory Notes with an aggregate principal balance of $1,680,000
were issued by the Company on September 28, 2009.





Since the
financing described in the preceding paragraph is in stages with over half of
the potential funding dependent on the occurrence of specific events and due to
the Company’ financial condition and to the significant uncertainties resulting
from the actions of the former CFO, there are can be no assurance that the
Company will be able to obtain the capital funds that will be needed for the
Company to continue it operations.





Results
of Operations





Comparison
of Nine-Month and Three-Month Periods Ended September 30, 2009 and
2008





Contract
and grant income increased by $1,097,000 and $644,000 during the nine-month and
three-month periods ended September 30, 2009, respectively, compared to the
corresponding periods for 2008 due to a $4 million contract that was started
during 2009.  The corresponding increases in cost of contract income
for the two periods, however, exceeded the revenue increases resulting in the
increases in the gross operating loss of $300,000 and $35,000 during the
nine-month and three-month periods ended September 30, 2009, respectively,
compared to the corresponding periods for 2008.


21





The
increases in general and administrative expenses during the 2009 periods
compared to the corresponding 2008 periods were due primarily to increased
insurance costs.  Selling expense increases during the 2009 periods
were consistent with the increases in contract income.  The
significant decreases in option expense during the 2009 periods were due to the
large stock option grants during 2008 compared to 2009.  Warrant
expense increased by $219,000 during the nine-month period ended September 30,
2009 compared to the corresponding period for 2008 due to the modification of
warrants held by the Quercus Trust (see Note 7 of Notes to Consolidated
Financial Statements).  The decreases in travel and entertainment
expenses during the 2009 periods compared to the corresponding 2008 periods were
due to the Company’s efforts to conserve cash during 2009 due to difficulties in
obtaining financing. Interest expense increased by $854,000 and $214,000 during
the nine-month and three-month periods ended September 30, 2009, respectively,
compared to the corresponding periods for 2008 due to the $2,000,000 net
increase in outstanding debt between the September 30, 2009 and September 30,
2008 and the effect of amortization of debt discount.  Included in
interest expense are $1,213,000 and $595,000 of amortization of debt discount
for the nine months ended September 30, 2009 and 2008, respectively, and
$467,000 and $310,000 for the three months ended September 30, 2009 and 2008,
respectively.





Liquidity
and Capital Resources Discussion





Historical
View




The
Company has historically lacked the financial and other resources necessary to
market the Technologies or to build demonstration projects without the financial
backing of government or industrial partners.  During the nine months
ended September 30, 2009 and 2008, the Company funded its operations primarily
from the sale of convertible debt and restricted stock, generally from
stockholders and other related parties.





Cash used
in operations amounted to $3,132,000 and $5,764,000 for the nine months ended
September 30, 2009 and 2008, respectively.  The majority of cash used
in operating activities during those periods ended relates to cash utilized in
our on-going operations, as adjusted for non-cash items, and changes in
operating assets and liabilities as detailed in the Consolidated Statements of
Cash Flows included herein.  The significant decrease in cash used in
operations during 2009 compared to 2008 was due primarily to the difficulties
experienced by the Company in obtaining financing during 2009.





Current
Cash Requirements; Need for Additional Funds





At
September 30, 2009, the Company did not have sufficient working capital to
satisfy its anticipated operating expenses for the next 12 months. As of
September 30, 2009, the Company had a cash balance of approximately $743,000 and
current liabilities of approximately $13.2 million, which consisted primarily of
convertible debt in default of $3,708,000 (net of $209,000 of debt discounts),
contingent liability reserves of $3,154,000 and unpaid payroll taxes of
$2,442,000.





Recent
events have had a significant adverse effect on the Company’s
liquidity.  The Company’s former CFO’s actions regarding payroll tax
matters resulted in an accrual during the fourth quarter of 2008 of an
additional $1,064,000 of payroll taxes and $2,105,000 of estimated interest and
penalties for late filing of the tax returns and nonpayment of the payroll taxes
(see Note 10 of Notes to Consolidated Financial Statements for further
information regarding payroll tax matters).





The
Company may become subject to tax liens if it cannot satisfactorily settle the
outstanding payroll tax liabilities.  Furthermore, due to the actions
of the CFO, the Company may also face criminal and/or civil action with respect
to the impact of the payroll tax matters.  The Company cannot predict
what, if any, actions may be taken by the tax authorities or other parties or
the effect the actions may have on the Company’s results of operations,
financial condition or cash flows.


22




Management
has determined that obtaining substantial additional funding is essential to its
continued existence.  Management actively engaged in negotiations with
a group of investors that had provided funding to the Company in the
past.  As more fully described in Note 4 of Notes to the Consolidated
Financial Statements, the Company and the investor group approved a term sheet
on September 16, 2009 for a Series B Convertible Preferred Stock financing that,
if fully funded, would result in cash proceeds to the Company of
$6,250,000.  The financing provides for funding in four tranches, with
the first and second tranche amounts totaling $3,050,000 based on specified time
periods and the third and fourth tranche amounts totaling $3,200,000 based on
the occurrence of specified events.  The first tranche Secured
Convertible Promissory Notes with an aggregate principal balance of $1,680,000
were issued by the Company on September 28, 2009.





Since the
financing described in the preceding paragraph is in stages, with over half of
the potential funding dependent on the occurrence of specific events, and due to
the Company’ financial condition and to the significant uncertainties resulting
from the actions of the former CFO, there are can be no assurance that the
Company will be able to obtain the capital funds that will be needed for the
Company to continue it operations.





Management anticipates
that its cash requirements during the next 12 months will be approximately $6
million.





In the
event that the Company cannot raise the necessary capital to fund the Company’s
future operations and development activities, the Company will not be able to
continue its operations.





Item
3.  Quantitative and Qualitative Disclosures About Market
Risk




Not
required.




Item
4T. Controls and Procedures.




The
Company, under the direction of its Chief Executive Officer and Chief Financial
Officer, have established disclosure controls and procedures that are designed
to ensure that information required to be disclosed by the Company in the
reports that it files or submits under the Exchange Act, is recorded, processed,
summarized, and reported within the time periods specified in the Commission’s
rules and forms. The disclosure controls and procedures are also intended to
ensure that such information is accumulated and communicated to the Company’s
management, consisting of the Chief Executive Officer and Chief Financial
Officer, as appropriate to allow timely decisions regarding required
disclosures.




The Chief
Executive Officer and Chief Financial Officer have reviewed and evaluated the
Company’s disclosure controls and procedures as of the end of the period covered
by this report. Based on, and as of the effective date of, that review and
evaluation, the Chief Executive Officer and Chief Financial Officer have
concluded that the Company did not maintain effective internal control over
financial reporting as of September 30, 2009.  Specifically, we have
determined that our internal controls as of September 30, 2009 were deficient in
that (i) we had not adequately allocated resources to ensure that necessary
internal controls were implemented and followed throughout the Company, (ii) our
period-end reporting process did not provide sufficiently timely and accurate
financial statements and required disclosures, (iii) there was a lack of
segregation of duties in the Company’s significant accounting functions, (iv)
our contract administration and accounting procedures were deficient, and (v)
our former Chief Financial Officer engaged in acts that resulted in significant
adjustments to the Company’s consolidated financial statements and subjected the
Company to potential criminal and/or civil action with respect to the Company’s
unpaid payroll tax matters (see Note 10 of Notes to the Consolidated Financial
Statements).  The former Chief Financial Officer resigned on August 3,
2009 following a vote by the Company’s Board of Directors to terminate his
employment for cause.  Mr. Arthur S. Reynolds, a member of the
Company’s Board of Directors, was appointed Interim Chief Financial
Officer.




Management
has discussed its conclusions regarding the inadequacy of internal controls with
the Audit Committee and with representatives of our independent public
accountants and intends to address the remediation process for the material
weaknesses noted and the Company’s Section 404 reporting responsibilities during
the fourth quarter of 2009.


23




As of the
end of the period covered by this report, the Company carried out an evaluation,
under the supervision and with the participation of the Company’s Chief
Executive Officer and Chief Financial Officer, of the effectiveness of
disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e)
of the Exchange Act.  Based on such evaluation, the Company’s Chief
Executive Officer and Chief Financial Officer have concluded that as of the end
of the period covered by this report, the Company’s disclosure controls and
procedures were not effective at meeting their objectives in that our
period-ending reporting process did not provide sufficiently timely and accurate
financial statements and disclosures.




There
have been no changes in the Company’s internal control over financial reporting
that occurred during the quarter ended September 30, 2009 that have materially
affected, or are reasonably likely to materially affect, the Company’s internal
control over financial reporting.




PART
II — OTHER INFORMATION




Item
1. Legal Proceedings




On April
6, 2009, David Gelbaum, as Trustee of The Quercus Trust (“Quercus”) brought an
action in the Delaware Chancery Court against the Company to enforce the
provisions of the Securities Purchase Agreement between Quercus and the Company
dated December 18, 2007 (the “Delaware Complaint”).  The Delaware
complaint sought specific enforcement of the Company’s “shelf” registration
obligation with respect to the shares of common stock issued or issuable to
Quercus pursuant to such agreement and the payment of liquidation damages for
the failure to register the securities.





On April
29, 2009, Quercus brought an action in the United States District Court for the
Eastern District of Arkansas against the Company (the “Arkansas Complaint’) to
enforce the provisions of the 2008 Agreement for the $2,000,000 Convertible
Note. The Arkansas Complaint alleged that, as a result of the events of default,
the Note was due and payable and sought judgment in the amount of the Note (plus
costs of collection).  The Arkansas Complaint also alleged that we
have breached our shelf registration obligation with respect to the shares of
our Common Stock issuable upon conversion of the Note or upon exercise of the
warrant issued to Quercus pursuant to the 2008 Agreement and sought liquidated
damages for the failure to register such shares.





On
September 28, 2009, the Arkansas Complaint was dismissed.  On
September 30, 2009, the Delaware Complaint was dismissed.





Item
1a.  Risk Factors




There
have been no material changes from the risk factors disclose in Item 1A to Part
I of our Annual Report on Form 10-K for the year ended December 31,
2008.




Item
2. Unregistered Sales of Equity Securities and Use of Proceeds




On August
21, 2009, we issued to Focus Fund, L.P. (“Focus Fund”) our 8% Secured
Convertible Promissory Note in the principal amount of $600,000.  The
Convertible Note is dated as of July 31, 2009, the date on which Focus Fund
advanced to us the first installment of the principal amount covered by the
Convertible Note.




The
Convertible Note bears interest at the rate of 8% per annum and becomes due and
payable on the earlier to occur of (i) the closing of an equity or convertible
debt investment (a “Financing”) yielding gross proceeds to us of not less than
$2,000,000 or (ii) December 31, 2011 (in either case, the “Maturity
Date”).  We have agreed that, unless the holder of the Convertible
Note (the “Holder”) is participating as an investor in the Financing, we shall,
at least ten (10) days prior to the initial closing of the Financing, give the
Holder written notice setting forth the details of the Financing (including,
without limitation, the terms of the securities to be issued in the Financing
(the “Financing Securities”), the price per share at which such Financing
Securities will be issued (the “Financing Price”) and the expected gross
proceeds to us) (the “Financing Notice”).  Upon the initial closing of
the Financing, the entire outstanding principal amount of the Convertible Note,
plus any accrued and unpaid interest thereon, shall convert automatically in
Financing Securities at the Financing Price.


24




The
Holder has the right at any time and from time to time until the principal and
interest on the Convertible Note has been paid in full, to convert the
outstanding principal amount of the Convertible Note, and any accrued and unpaid
interest thereon, into shares of our Common Stock at a price of $0.30 per
share.  The Convertible Note may not be prepaid without the prior
written consent of the Holder.




The
Convertible Note contains other conventional provisions, including for the
acceleration of our repayment obligations upon the occurrence of certain
specified Events of Default.





Our
obligations under the Convertible Note are secured, pursuant to a Security
Agreement dated as of July 31, 2009, by the grant to Focus Fund of a security
interest in the entirety of our Membership Interest (representing an 85%
beneficial ownership) in ThermoEnergy Power Systems, LLC (“TEPS”) and any and
all proceeds from the transfer, assignment or other permitted disposition
thereof.  TEPS is the subsidiary through which we conduct the Power
segment of our business.  TEPS holds the patent on the ThermoEnergy
Integrated Power Systems Technology, a power plant design that utilizes an
alternative thermodynamic combustion pathway that eliminates atmospheric
emissions of mercury, acid gasses and particulates and captures carbon dioxide
in pressurized liquid form.   TEPS holds a 50% membership
interest in Thermo-Babcock Carbon Capture LLC.





In
connection with the Convertible Note, on August 21, 2009 we issued to Focus Fund
a Common Stock Purchase Warrant entitling the holder thereof to purchase, at a
exercise price of $0.50 per share (subject to adjustment for certain
extraordinary corporate events as set forth in the Warrant) that number of
shares of our Common Stock determined by dividing (i) 200% of the aggregate
amount advanced by Focus Fund to us under the Convertible Note by (ii) the
exercise price.  The exercise price represents a premium of
approximately 60% over the closing price for our Common Stock in the
over-the-counter market on July 31, 2009 (the effective date of the Warrant) and
a premium of approximately 25% over the closing price for our Common Stock on
August 21, 2009 (the date on which the Warrant was issued).





The
Warrant may be exercised at any time on or before July 31, 2014, subject to our
right to accelerate the expiration date in the event the closing price for our
Common Stock exceeds $0.622 per share (200% of the closing price on July 31,
2009) for a period of 30 consecutive trading days.





If, in
connection with the Financing, we issue to investors warrants, options or other
rights to purchase shares of our Common Stock (the “Financing Warrants”) at an
exercise price per share less than the Exercise Price then in effect for the
Warrant, then, upon issuance of such Financing Warrants, the Exercise Price of
the Warrant shall be adjusted automatically to a price equal to the lowest
exercise price per share at which our Common Stock may be purchased under the
Financing Warrants.  Further, if any of the Financing Warrants has an
expiration date later than the expiration date then in effect for the Warrant,
then, upon issuance of such Financing Warrants, the expiration date of the
Warrant shall be extended to the date that is the latest date on which any of
such Financing Warrants may be exercised.





The
Warrant contains other conventional terms, including provisions for adjustment
in the Exercise Price and/or the securities issuable upon exercise of the
Warrant in the event of certain specified extraordinary corporate events such as
stock splits, combinations, and stock dividends.





Focus
Fund is the beneficial owner of approximately 7.1% of our outstanding Common
Stock (before giving effect to the Convertible Note or the
Warrant).  J. Winder Hughes III, a member of our Board of Directors,
is the Managing Partner of Hughes Capital Investors, LLC, the fund manager of
Focus Fund.





On August
25, 2009, we issued to Focus Fund our Promissory Note in the principal amount of
$110,000 (the “Bridge Note”).  The Bridge Note bears interest at the
rate of 15% per annum.  A portion of the principal amount of the
Bridge Note, in the amount of $55,000, together with all interest then accrued
and unpaid under the Bridge Note, is due and payable on September 4, 2009. The
entire unpaid principal amount, together with all interest then accrued and
unpaid under the Bridge Note, is due and payable on September 28,
2009.  All or any portion of the Bridge Note may be pre-paid without
premium or penalty, at our election, with partial payments being credited first
against accrued and unpaid interest and the balance, if any, against
principal.


25




In
connection with the issuance of the Bridge Note, we agreed that, whether or not
any portion of the Bridge Note then remains outstanding, we will, upon the
initial closing of an equity or convertible debt investment yielding gross
proceeds to us of not less than $2,000,000 (a “Financing”), issue to the holder
of the Bridge Note a warrant entitling such holder to purchase, at any time on
or before the fifth anniversary of the date of the initial closing of the
Financing, such number of the securities to be issued in the Financing (the
“Financing Securities”) as shall be determined by dividing (i) $110,000 by (ii)
the price per share at which such Financing Securities will be issued (the
“Financing Price”).  The price per share at which such warrant may be
exercised shall be equal to the Financing Price.




The
Bridge Note contains other conventional provisions, including for the
acceleration of our repayment obligations upon the occurrence of certain
specified Events of Default.




As
required under our Consulting Agreement  dated as of August 3, 2009
with Rexon Limited (“Rexon”), pursuant to which Arthur S. Reynolds, a member of
our Board of Directors, has provide services as our interim Chief Financial
Officer, as of the dates set forth below  we issued to Rexon, as
partial consideration for Mr. Reynolds’s services, warrants for the purchase of
that number of shares of our Common Stock set forth opposite such dates at the
exercise prices indicated (which, in each case, was the closing price for our
Common Stock on the date such warrant was issued).  Mr. Reynolds is
the sole beneficial owner of Rexon.
 
 Date
                              
                              Number of Shares
                              
                              
                              Exercise PriceAugust
      1, 2009
                              
                              
                              48,232
                              
                              
                              $
                              0.311September
      1, 2009
                              
                              
                              45,455
                              
                              
                              $
                              0.33October
      1, 2009
                              
                              
                              40,541
                              
                              
                              $
                              0.37November
      1, 2009
                              
                              
                              46,875
                              
                              
                              $
                              0.32




On
September 28, 2009, we issued to a group of investors our 8% Secured Convertible
Promissory Notes in the aggregate principal amount of $1,680,000.  The
Convertible Notes were issued to the following persons in the amounts
indicated:




Investor
                      
                      Note AmountEmpire
      Capital Partners, LP
                      
                      $
                      133,333Empire
      Capital Partners, Ltd
                      
                      $
                      133,333Empire
      Capital Partners Enhanced Master Fund, Ltd
                      
                      $
                      133,333Robert
      S. Trump
                      
                      $
                      1,000,000The
      Quercus Trust
                      
                      $
                      280,000




In
connection with the issuance of the Convertible Notes, on September 28, 2009 we
amended and restated the following outstanding promissory notes (the “Restated
Notes”) in the aggregate original principal amount of $3,400,000 held by the
investors to whom we issued Convertible Notes or their affiliates:




Note Holder
                      
                      Original Issuance
                        Date
                      
                      Principal AmountEmpire
      Capital Partners, LP
                      
                      April
      24, 2009
                      
                      $
                      100,000Empire
      Capital Partners, Ltd
                      
                      April
      24, 2009
                      
                      $
                      100,000Empire
      Capital Partners Enhanced Master Fund, Ltd
                      
                      April
      24, 2009
                      
                      $
                      100,000Scott
      A. Fine
                      
                      April
      24, 2009
                      
                      $
                      100,000Peter
      J. Richards
                      
                      April
      24, 2009
                      
                      $
                      100,000Robert
      S. Trump
                      
                      December 19, 2008
                      
                      $
                      500,000The
      Quercus Trust
                      
                      June
      25, 2009
                      
                      $
                      150,000The
      Quercus Trust
                      
                      February
      11, 2009
                      
                      $
                      250,000The
      Quercus Trust
                      
                      September 15, 2008
                      
                      $
                      2,000,000




As
amended, the Restated Notes are identical in form to the Convertible
Notes.  The Convertible Notes and the Restated Notes are also
identical in form to the 8% Secured Convertible Promissory Note in the principal
amount of $600,000 that we issued to Focus Fund, L.P. on August 21, 2009 (the
“Focus Fund Note”).  In connection with the transaction, on September
28, 2009, we amended and restated the Focus Fund Note to change the price at
which the principal and interest of the Focus Fund Note is convertible into
shares of our Common Stock from $0.30 per share to $0.24 per share (the same
price at which the Convertible Notes and the Restated Notes are convertible) and
to change the maturity date to December 31, 2010 (the maturity date of the
Convertible Notes and the Restated Notes).  The Convertible Notes, the
Restated Notes and the Focus Fund Note, as so amended, are referred to herein as
the “Notes” and the holders of the Notes are referred to herein as the
“Investors”.




The Notes
bear interest at the rate of 8% per annum and become due and payable on the
earlier to occur of (i) the closing of the Second Tranche of the Series B
Convertible Preferred Stock financing contemplated by that certain Term Sheet
dated September 16, 2009 and executed by the Investors (the “Financing”) or (ii)
December 31, 2010.  Upon the closing of the Second Tranche of the
Financing, the entire outstanding principal amount of the Notes, plus any
accrued and unpaid interest thereon, shall convert automatically into the
securities to be issued in the Financing (the “Financing Securities”) at the
price per share at which such Financing Securities will be issued in the
Financing.


26




The
Investors have the right at any time and from time to time until the principal
and interest on the Notes have been paid in full, to convert the outstanding
principal amount of the Notes, and any accrued and unpaid interest thereon, into
shares of our Common Stock at a price of $0.24 per share (the “Conversion
Price”).  The Conversion Price represents a discount of approximately
38% below the closing price for our Common Stock in the over-the-counter market
on September 28, 2009 (the date on which the Convertible Notes were issued
and the Restated Notes and Focus Fund Notes were amended).  The Notes
may not be prepaid without the prior written consent of the
Investors.




The Notes
contain other conventional provisions, including for the acceleration of our
repayment obligations upon the occurrence of certain specified Events of
Default.





Our
obligations under the Notes are secured, pursuant to a Security Agreement dated
as of September 28, 2009, by the grant to the Investors of a security interest
in the entirety of our Membership Interest (representing an 85% beneficial
ownership) in TEPS and any and all proceeds from the transfer, assignment or
other permitted disposition thereof.  TEPS holds a 50% membership
interest in Thermo-Babcock Carbon Capture LLC.





In
connection with the issuance of the Convertible Notes, on September 28, 2009 we
issued, to the Investors who purchased Convertible Notes, Common Stock Purchase
Warrants entitling the holder thereof to purchase, at a exercise price of $0.50
per share (subject to adjustment for certain extraordinary corporate events as
set forth in the Warrant) that number of shares of our Common Stock determined
by dividing (i) 200% of the principal amounts of their respective Convertible
Notes by (ii) the exercise price.  The exercise price represents a
premium of approximately 28% over the closing price for our Common Stock in the
over-the-counter market on September 28, 2009  (the date on which the
Warrants were issued).




The
Warrants may be exercised at any time on or before September 30, 2014, subject
to our right to accelerate the expiration date in the event the closing price
for our Common Stock exceeds $0.78 per share (200% of the closing price on
September 28, 2009) for a period of 30 consecutive trading days.





The
Warrants contain other conventional terms, including provisions for adjustment
in the exercise price and/or the securities issuable upon exercise in the event
of certain specified extraordinary corporate events, such as stock splits,
combinations, and stock dividends.





In
connection with the amendment of the Restated Notes and the Focus Fund Note, on
September 28, 2009 we amended the following outstanding Common Stock Purchase
Warrants that had been issued to Investors in connection with the issuance of
such Notes, in order to reduce the exercise price thereof to $0.50 per
share:




Warrant Holder
                      
                      Date
                      
                      Warrant
                        Shares
                      
                      
                      Original Exercise
                        PriceEmpire
      Capital Partners, LP
                      
                      April
      24, 2009
                      
                      
                      500,000
                      
                      
                      $
                      0.55Empire
      Capital Partners, Ltd
                      
                      April
      24, 2009
                      
                      
                      500,000
                      
                      
                      $
                      0.55Empire
      Capital Partners Enhanced Master Fund, Ltd
                      
                      April
      24, 2009
                      
                      
                      500,000
                      
                      
                      $
                      0.55Scott
      A. Fine
                      
                      April
      24, 2009
                      
                      
                      500,000
                      
                      
                      $
                      0.55Peter
      J. Richards
                      
                      April
      24, 2009
                      
                      
                      500,000
                      
                      
                      $
                      0.55Robert
      S. Trump
                      
                      August 12, 2008
                      
                      formula-based
                      
                      
                      $
                      1.50Focus
      Fund, L.P.
                      
                      June
      17, 2009
                      
                      
                      600,000
                      
                      
                      $
                      0.54





As a
result of our issuance of the Convertible Notes and the amendment of the
Restated Notes and the Focus Fund Note, the exercise prices of certain Common
Stock Purchase Warrants issued by us to The Quercus Trust (“Quercus”), one of
the Investors, in December 2007 and September 2008, entitling Quercus to
purchase up to an aggregate of 14,000,000 shares of our Common Stock were
automatically reduced, in accordance with the terms of such outstanding
warrants, the $0.36 per share.  The reduction in exercise price did
not affect the number of shares of our Common Stock issuable upon exercise of
such outstanding warrants.


27




J. Winder
Hughes III, a member of our Board of Directors, is the Managing Partner of
Hughes Capital Investors, LLC, the fund manager of Focus Fund, LLC, one of the
Investors.




The
Convertible Notes and Warrants described above were issued on September 28, 2009
in a transaction not involving a public offering and without registration under
the Securities Act of 1933 in reliance on the exemption from registration
provided by Section 4(2) of such Act.  We intend to use the proceeds
from the sale of the Notes and Warrants for working capital purposes, to
purchase fixed assets used in the development or production of the Company’s
products, to repay debt and for investment in new technologies related to the
Company’s business.




For its
services in connection with our sale of a Convertible Note and a Warrant to
Quercus, one of the Investors, we are obligated to pay Merriman Curhan Ford
& Co. a placement fee of $20,000 and to issue to that firm a Warrant (in
form substantially identical to the Warrant issued to The Quercus Trust) for the
purchase of 80,000 shares of our Common Stock.  The Warrant will be
issued to Merriman Curhan Ford & Co. in a transaction not involving a public
offering and without registration under the Securities Act of 1933 in reliance
on the exemption from registration provided by Section 4(2) of such
Act.





Item
3. Defaults Upon Senior Securities




On July
2, 2007, the Company issued Convertible Promissory Notes in the aggregate
principal amount of $3,353,127 (the “Notes”) as part of the consideration for
the acquisition of CASTion.  The balance of the Notes is technically
in default as of September 30, 2009, due to the fact that the Company had not
made the required prepayments from the Quercus private placement of equity
closed on December 17, 2007.




Item
4. Submission of Matters to a Vote of Security Holders




No
matters were submitted to a vote of securities holders during the quarter ended
September 30, 2009.




Item
5. Other Information




None.




Item
6. Exhibits




The
following exhibits are filed as part of this report:


Exhibit No.
                        
                        Description of Exhibit4.1
                        
                        8%
      Secured Convertible Promissory Note in the principal amount of $600,000
      issued to Focus Fund L.P.  — Incorporated by reference to
      Exhibit 10.1 to Current Report on Form 8-K filed August 27,
      20094.2
                        
                        Common
      Stock Purchase Warrants issued to Focus Fund L.P. — Incorporated by
      reference to Exhibit 4.1 to Current Report on Form 8-K filed August 27,
      20094.3
                        
                        Form
      of  8% Secured Convertible Promissory Notes issued
      to  issued to Empire Capital Partners, LP, Empire Capital
      Partners, Ltd,  Empire Capital Partners Enhanced Master Fund,
      Ltd, Robert S. Trump and The Quercus Trust — Incorporated by reference to
      Exhibit 4.1 to Current Report on Form 8-K filed October 2,
      20094.4
                        
                        Form
      of Common Stock Purchase Warrants issued to Empire Capital Partners, LP,
      Empire Capital Partners, Ltd,  Empire Capital Partners Enhanced
      Master Fund, Ltd, Robert S. Trump and The Quercus Trust — Incorporated by
      reference to Exhibit 4.2 to Current Report on Form 8-K filed October 2,
      200910.1
      *
                        
                        Consulting
      Services Agreement between Rexon Limited and ThermoEnergy Corporation
      dated as of August 3, 2009  — Incorporated by reference to
      Exhibit 10.1 to Current Report on Form 8-K filed August 26,
      200910.2
      *
                        
                        Form
      of Common Stock Purchase Warrant issued to Rexon Limited pursuant to
      Consulting Services Agreement between Rexon Limited and ThermoEnergy
      Corporation dated as of August 3, 2009 — Filed herewith10.3
      *
                        
                        Executive
      Employment Agreement dated September 16, 2009 by and between ThermoEnergy
      Corporation and Shawn R. Hughes  — Filed
  herewith10.4
                        
                        Security
      Agreement between The Focus Fund, L.P. and ThermoEnergy Corporation dated
      July 31, 2009  —  Incorporated by reference to Exhibit
      10.2 to Current Report on Form 8-K filed August 27,
200910.5
                        
                        Promissory
      Note in the principal amount of $110,000 issued pursuant to Focus Fund
      L.P.  — Incorporated by reference to Exhibit 10.1 to Current
      Report on Form 8-K filed August 31, 200910.6
                        
                        Security
      Agreement dated as of September 28, 2009 between ThermoEnergy Corporation
      and Empire Capital Partners, LP, Empire Capital Partners,
      Ltd,  Empire Capital Partners Enhanced Master Fund, Ltd, Robert
      S. Trump and The Quercus Trust — Incorporated by reference to Exhibit 10.1
      to Current Report on Form 8-K filed October 2, 200931.1
                        
                        Sarbanes
      Oxley Act Section 302 Certificate of Principal Executive
      Officer  — Filed herewith31.2
                        
                        Sarbanes
      Oxley Act Section 302 Certificate of Principal Financial
      Officer  — Filed herewith32.1
                        
                        Sarbanes
      Oxley Act Section 906 Certificate of Principal Executive
      Officer  — Filed herewith32.2
                        
                        Sarbanes
      Oxley Act Section 906 Certificate of Principal Financial
      Officer  — Filed
herewith
 
 *  May
be deemed a compensatory plan or
arrangement




28





SIGNATURE




In
accordance with the requirements of the Securities Exchange Act of 1934, as
amended, the registrant caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.




Date:
November 16, 2009


THERMOENERGY
      CORPORATION/s/ Arthur S. ReynoldsArthur
      S. ReynoldsChief Financial
      Officer




29