UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q





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





For
the quarterly period ended September 30, 2010





or





 ̈
            TRANSITION
      REPORT PURSUANT TO 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
            71-0659511(State
      or Other Jurisdiction of
            (I.R.S.
      Employer Identification No.)Incorporation
      or Organization)





124
      West Capitol Avenue, Suite 880,Little
      Rock, Arkansas
              72201(Address
      of Principal Executive Offices)
              (Zip
      Code)





(501)
376-6477


Registrant’s
Telephone Number, Including Area Code:





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 (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. Yes x No  ̈





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 (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files). Yes x  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
the 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 company x





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). Yes  ̈ No x





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


Class –
Common Stock, $.001 par
value                        Outstanding
at November 9, 2010 – 55,481,918 shares





THERMOENERGY
CORPORATION





INDEX





Page
                        No.Part
      I.
                      Financial
      InformationITEM
      1.
                      Financial
      Statements
                      
                      3Consolidated
      Balance Sheets as of September 30, 2010 (Unaudited) and December 31,
      2009
                      
                      3Consolidated
      Statements of Operations for the nine and three months ended September 30,
      2010 and 2009 (Unaudited)
                      
                      4Consolidated
      Statements of Cash Flows for the nine months ended September 30, 2010 and
      2009 (Unaudited)
                      
                      5Notes
      to Consolidated Financial Statements (Unaudited)
                      
                      6ITEM
      2.
                      Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
                      
                      16ITEM
      3.
                      Quantitative
      and Qualitative Disclosures About Market Risk
                      
                      19ITEM
      4.
                      Controls
      and Procedures
                      
                      19Part
      II.
                      Other
      InformationITEM
      1.
                      Legal
      Proceedings
                      
                      20ITEM
      1A.
                      Risk
      Factors
                      
                      20ITEM
      2.
                      Unregistered
      Sales of Equity Securities and Use of Proceeds
                      
                      20ITEM
      3.
                      Defaults
      Upon Senior Securities
                      
                      20ITEM
      4.
                      Other
      Information
                      
                      20ITEM
      5.
                      Exhibits
                      
                      21Signatures
                      
                      
                      
                      22


2


PART
I – FINANCIAL INFORMATION





ITEM
1. Financial Statements





THERMOENERGY
CORPORATION


CONSOLIDATED
BALANCE SHEETS


(in
thousands, except share and par value amounts)





September 30,
                      2010
                    
                    
                    December 31,
                      2009(unaudited)ASSETSCurrent
      Assets:Cash
                    
                    $
                    5,703
                    
                    
                    $
                    1,109Accounts
      receivable, net
                    
                    
                    543
                    
                    
                    
                    7Inventories,
      net
                    
                    
                    65
                    
                    
                    
                    74Other
      current assets
                    
                    
                    172
                    
                    
                    
                    205Total
      Current Assets
                    
                    
                    6,483
                    
                    
                    
                    1,395Property
      and equipment, net
                    
                    
                    444
                    
                    
                    
                    241Other
      assets
                    
                    
                    66
                    
                    
                    
                    74Total
      Assets
                    
                    $
                    6,993
                    
                    
                    $
                    1,710LIABILITIES
      AND STOCKHOLDERS' EQUITY (DEFICIT)Current
      Liabilities:Accounts
      payable
                    
                    $
                    626
                    
                    
                    $
                    812Short-term
      borrowings
                    
                    
                    1,499
                    
                    
                    
                    —Convertible
      debt in default, net
                    
                    
                    5,333
                    
                    
                    
                    4,133Deferred
      revenue
                    
                    
                    757
                    
                    
                    
                    398Other
      current liabilities
                    
                    
                    3,370
                    
                    
                    
                    3,627Other
      accruals
                    
                    
                    2,962
                    
                    
                    
                    3,053Total
      Current Liabilities
                    
                    
                    14,547
                    
                    
                    
                    12,023Long
      Term Liabilities:Deferred
      compensation retirement plan for officers, net of current
      portion
                    
                    
                    192
                    
                    
                    
                    229Derivative
      liability
                    
                    
                    2,880
                    
                    
                    
                    2,559Convertible
      debt, net
                    
                    
                    1,214
                    
                    
                    
                    1,370Total
      Long Term Liabilities
                    
                    
                    4,286
                    
                    
                    
                    4,158Total
      Liabilities
                    
                    
                    18,833
                    
                    
                    
                    16,181Stockholders'
      Equity (Deficit):Preferred
      Stock, $0.01 par value, 20,000,000 shares authorized:Class
      A Convertible Preferred Stock, liquidation value of $1.20 per share;
      designated: 10,000,000 shares; issued and outstanding: 208,334 shares at
      September 30, 2010 and December 31, 2009
                    
                    
                    2
                    
                    
                    
                    2Class
      B Convertible Preferred Stock, liquidation preference of $2.40 per share;
      designated: 6,454,621 shares at September 30, 2010 and 4,371,287 shares at
      December 31, 2009; issued and outstanding: 5,912,956 shares at September
      30, 2010 and 3,037,954 shares at December 31, 2009
                    
                    
                    59
                    
                    
                    
                    30Common
      Stock, $.001 par value: authorized - 300,000,000 shares; issued:
      53,763,270 shares at September 30, 2010 and December 31, 2009;
      outstanding: 53,679,473 shares at September 30, 2010 and December 31,
      2009
                    
                    
                    54
                    
                    
                    
                    54Additional
      paid-in capital
                    
                    
                    77,823
                    
                    
                    
                    66,711Treasury
      stock, at cost: 50,000 shares at September 30, 2010
                    
                    
                    (18
                    )
                    
                    
                    —Accumulated
      deficit
                    
                    
                    (89,760
                    )
                    
                    
                    (81,268
                    )Total
      Stockholders’ Equity (Deficit)
                    
                    
                    (11,840
                    )
                    
                    
                    (14,471
                    )TOTAL
      LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
                    
                    $
                    6,993
                    
                    
                    $
                    1,710





See notes
to consolidated financial statements.


3


THERMOENERGY
CORPORATION


CONSOLIDATED
STATEMENTS OF OPERATIONS


(in
thousands, except share and per share amounts)


(Unaudited)





Nine Months Ended
                              September 30,
                            
                            
                            Three Months Ended
                              September 30,2010
                            
                            2009
                            
                            
                            2010
                            
                            
                            2009Contract
      and grant revenue
                            
                            $
                            2,054
                            
                            
                            $
                            2,608
                            
                            
                            $
                            641
                            
                            
                            $
                            970Less:
      cost of contract and grant revenue
                            
                            
                            1,912
                            
                            
                            
                            2,926
                            
                            
                            
                            608
                            
                            
                            
                            1,074Gross
      profit (loss)
                            
                            
                            142
                            
                            
                            
                            (318
                            )
                            
                            
                            33
                            
                            
                            
                            (104
                            )Operating
      Expenses:General
      and administrative
                            
                            
                            2,531
                            
                            
                            
                            3,714
                            
                            
                            
                            916
                            
                            
                            
                            1,572Engineering
      and R&D
                            
                            
                            418
                            
                            
                            
                            693
                            
                            
                            
                            77
                            
                            
                            
                            222Sales
      and marketing
                            
                            
                            810
                            
                            
                            
                            354
                            
                            
                            
                            271
                            
                            
                            
                            109Stock
      option expense
                            
                            
                            1,562
                            
                            
                            
                            211
                            
                            
                            
                            559
                            
                            
                            
                            30Warrant
      expense
                            
                            
                            —
                            
                            
                            
                            1,757
                            
                            
                            
                            —
                            
                            
                            
                            727Total
      operating expenses
                            
                            
                            5,321
                            
                            
                            
                            6,729
                            
                            
                            
                            1,823
                            
                            
                            
                            2,660Loss
      from operations
                            
                            
                            (5,179
                            )
                            
                            
                            (7,047
                            )
                            
                            
                            (1,790
                            )
                            
                            
                            (2,764
                            )Other
      income (expense):Derivative
      income (loss)
                            
                            
                            (321
                            )
                            
                            
                            —
                            
                            
                            
                            2,635
                            
                            
                            
                            —Loss
      on extinguishment of debt
                            
                            
                            (614
                            )
                            
                            
                            (1,208
                            )
                            
                            
                            (614
                            )
                            
                            
                            (1,208
                            )Interest
      expense, net
                            
                            
                            (2,311
                            )
                            
                            
                            (1,800
                            )
                            
                            
                            (1,150
                            )
                            
                            
                            (651
                            )Equity
      in losses of joint venture
                            
                            
                            (67
                            )
                            
                            
                            —
                            
                            
                            
                            (3
                            )
                            
                            
                            —Net
      loss
                            
                            
                            (8,492
                            )
                            
                            
                            (10,055
                            )
                            
                            
                            (922
                            )
                            
                            
                            (4,623
                            )Deemed
      dividend on Series B Convertible Preferred Stock
                            
                            
                            (6,900
                            )
                            
                            
                            —
                            
                            
                            
                            (6,900
                            )
                            
                            
                            —Net
      loss attributable to common stockholders
                            
                            $
                            (15,392
                            )
                            
                            $
                            (10,055
                            )
                            
                            $
                            (7,822
                            )
                            
                            $
                            (4,623
                            )Loss
      per share attributable to common stockholders, basic and
      diluted
                            
                            $
                            (0.29
                            )
                            
                            $
                            (0.19
                            )
                            
                            $
                            (0.15
                            )
                            
                            $
                            (0.09
                            )Shares
      used in computing loss per share, basic and diluted
                            
                            
                            53,679,473
                            
                            
                            
                            52,507,777
                            
                            
                            
                            53,679,473
                            
                            
                            
                            53,454,293





See notes
to consolidated financial statements.


4


THERMOENERGY
CORPORATION


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(in
thousands)


(Unaudited)





Nine Months Ended
                      September 30,2010
                    
                    
                    2009Operating
      Activities:Net
      loss
                    
                    $
                    (8,492
                    )
                    
                    $
                    (10,055
                    )Adjustment
      to reconcile net loss to net cash used in operating
      activities:Stock
      option expense
                    
                    
                    1,562
                    
                    
                    
                    211Warrant
      expense
                    
                    
                    —
                    
                    
                    
                    1,757Warrants
      issued for services
                    
                    
                    —
                    
                    
                    
                    46Common
      stock issued for services
                    
                    
                    —
                    
                    
                    
                    188Loss
      on extinguishment of debt
                    
                    
                    614
                    
                    
                    
                    1,208Equity
      in losses of joint venture
                    
                    
                    67
                    
                    
                    
                    —Derivative
      loss
                    
                    
                    321
                    
                    
                    
                    —Non-cash
      interest added to debt
                    
                    
                    490
                    
                    
                    
                    163Depreciation
                    
                    
                    36
                    
                    
                    
                    48Provision
      for inventory reserves
                    
                    
                    9
                    
                    
                    
                    —Amortization
      of discount on convertible debt
                    
                    
                    1,444
                    
                    
                    
                    1,213Increase
      (decrease) in cash arising from changes in assets and
      liabilities:Accounts
      receivable
                    
                    
                    (536
                    )
                    
                    
                    99Other
      current assets
                    
                    
                    33
                    
                    
                    
                    128Accounts
      payable
                    
                    
                    (186
                    )
                    
                    
                    346Deferred
      revenue
                    
                    
                    359
                    
                    
                    
                    168All
      other current liabilities
                    
                    
                    (42
                    )
                    
                    
                    1,409Deferred
      compensation retirement plan
                    
                    
                    (37
                    )
                    
                    
                    (11
                    )Net
      cash used in operating activities
                    
                    
                    (4,358
                    )
                    
                    
                    (3,082
                    )Investing
      Activities:Investment
      in joint venture
                    
                    
                    (59
                    )
                    
                    
                    (50
                    )Purchase
      of property and equipment
                    
                    
                    (239
                    )
                    
                    
                    —Net
      cash used in investing activities
                    
                    
                    (298
                    )
                    
                    
                    (50
                    )Financing
      Activities:Proceeds
      from short-term borrowings
                    
                    
                    4,625
                    
                    
                    
                    —Proceeds
      from issuance of Series B Convertible Preferred Stock and warrants, net of
      issuance costs of $375 in 2010
                    
                    
                    4,625
                    
                    
                    
                    —Proceeds
      from issuance of Common Stock and warrants
                    
                    
                    —
                    
                    
                    
                    500Proceeds
      from convertible promissory notes
                    
                    
                    —
                    
                    
                    
                    3,260Net
      cash provided by financing activities
                    
                    
                    9,250
                    
                    
                    
                    3,760Net
      change in cash
                    
                    
                    4,594
                    
                    
                    
                    628Cash,
      beginning of period
                    
                    
                    1,109
                    
                    
                    
                    115Cash,
      end of period
                    
                    $
                    5,703
                    
                    
                    $
                    743Supplemental
      schedule of non-cash financing activities:Conversion
      of short-term borrowings and accrued interest to Series B Convertible
      Preferred Stock
                    
                    $
                    1,900
                    
                    
                    $
                    —Debt
      discount recognized on short-term borrowings
                    
                    $
                    3,054
                    
                    
                    $
                    —Non-cash
      interest added to debt
                    
                    $
                    323
                    
                    
                    $
                    52Receipt
      of treasury stock
                    
                    $
                    18
                    
                    
                    $
                    —





See notes
to consolidated financial statements.


5


THERMOENERGY
CORPORATION


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


September
30, 2010





Note 1: Basis of
presentation and summary of signification accounting
policies





Principles
of consolidation and basis of presentation





The
consolidated financial statements include the accounts of ThermoEnergy
Corporation and its wholly-owned subsidiaries (the “Company”). All significant
intercompany accounts and transactions have been eliminated in consolidation.
Certain prior year amounts have been reclassified to conform to current year
classifications.





The
accompanying unaudited consolidated financial statements have been prepared in
accordance with the instructions to Form 10-Q and Rule 8-03 of Regulation S-X.
In accordance with such rules and regulations, certain information and footnote
disclosures normally included in financial statements prepared in accordance
with accounting principles generally accepted in the United States of America
(“GAAP”) have been omitted, although the Company believes the disclosures
included herein are adequate to make the information presented not
misleading.





In the
opinion of management, all adjustments consisting of normal recurring
adjustments considered necessary for a fair presentation have been included.
Operating results for the three and nine-month periods ended September 30, 2010
are not necessarily indicative of the results that may be expected for the year
ending December 31, 2010.





Net loss
attributable to common shareholders 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 the dilutive effect of the
Company’s convertible debt, Class A Convertible Preferred Stock and Class B
Convertible Preferred Stock were not included in the computation of diluted loss
per share since the effect would be anti-dilutive.





The
balance sheet at December 31, 2009 has been derived from the audited financial
statements at that date.





For
further information, refer to the financial statements and footnotes thereto
included in the Company’s annual report on Form 10-K/A for the year ended
December 31, 2009.





Revenue
recognition





Revenues
from fixed-price contracts are recognized on the percentage-of-completion
method, measured by the percentage of costs incurred to total estimated costs.
Contract costs include all direct material and labor costs and indirect costs
related to contract performance, such as indirect labor, supplies, tools,
repairs and depreciation. Selling and general and administrative costs are
charged to expense as incurred. Provisions for estimated losses on uncompleted
contracts are made in the period in which losses are determined. Changes in job
performance, job conditions, and estimated profitability may result in revisions
to costs and revenue and are recognized in the period in which revisions are
determined. Revenue earned from grants are based on allowable costs and
labor.





In
circumstances when the Company cannot estimate the final outcome of a contract,
or when the Company cannot reasonably estimate revenue, the Company utilizes the
percentage-of-completion method based on a zero profit margin until more precise
estimates can be made.





Accounts
receivable, net





Accounts
receivable are recorded at their estimated net realizable value. Receivables
related to the Company’s contracts and grants have realization and liquidation
periods of less than one year and are therefore classified as current. The
allowance for doubtful accounts totaled $109,000 at September 30, 2010 and
December 31, 2009. The Company’s method for estimating its allowance for
doubtful accounts is based on judgmental factors, including known and inherent
risks in the underlying balances, adverse situations that may affect the
customer’s ability to pay and current economic conditions. Amounts considered
uncollectible are written off based on the specific customer balance
outstanding.





Inventories





Inventories
are stated at the lower of cost of market using the first-in, first-out method
and consist primarily of raw materials and supplies.


6


THERMOENERGY
CORPORATION


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


September
30, 2010





We
evaluate our inventory for excess quantities and obsolescence periodically. In
preparing our evaluation, we look at the expected demand for our products for
the next three to twelve months in order to determine whether such equipment
requires a change in the inventory reserve in order to record the inventory at
net realizable value. Based on this evaluation, we establish and maintain a
reserve so that inventory is appropriately stated at the lower of cost or net
realizable value. Inventory reserves totaled $83,000 and $74,000 at September
30, 2010 and December 31, 2009, respectively.





Property
and equipment





Property
and equipment are stated at cost and are depreciated over the estimated useful
life of each asset. Depreciation is computed using the straight-line method. The
Company evaluates long-lived assets based on estimated future undiscounted net
cash flows or other fair value measures whenever significant events or changes
in circumstances occur that indicate the carrying amount may not be recoverable.
If that evaluation indicates that an impairment has occurred, a charge is
recognized to the extent the carrying amount exceeds the discounted cash flows
or fair values of the asset, whichever is more readily
determinable.





Contingencies





The
Company accrues for costs relating to litigation, including litigation defense
costs, claims and other contingent matters, including liquidated damage
liabilities, when such liabilities become probable and reasonably estimable.
Such estimates may be based on advice from third parties or on management’s
judgment, as appropriate. Revisions to accruals are reflected in income in
the period in which different facts or information become known or circumstances
change that affect the Company’s previous assumptions with respect to the
likelihood or amount of loss. Amounts paid upon the ultimate resolution of
liabilities may be materially different from previous estimates and could
require adjustments to the estimated accruals to be recognized in the period
such new information becomes known.





Stock
options





The
Company accounts for stock options in accordance with Accounting Standards
Codification (“ASC”) Topics 505 and 718. Accordingly, the cost of all
share-based payments to employees, including grants of employee stock options,
are recognized in the financial statements based on their fair values on the
measurement date, which is generally the date of grant. Such cost is recognized
over the vesting period of the awards. The Company uses the Black-Scholes option
pricing model to estimate the fair value of stock option awards.





Series
B Convertible Preferred Stock





The
Company has accounted for its Series B Convertible Preferred Stock by allocating
the proceeds based on the relative fair value of the Series B Convertible
Preferred Stock and the warrants issued to the investors, and then to any
beneficial conversion features contained in the Preferred Stock. The Company
determined the initial value of the Series B Convertible Preferred Stock and
investor warrants using valuation models it considers to be appropriate. As the
Series B Convertible Preferred Stock has an indefinite life, it is classified
within the stockholders’ equity (deficit) section of the Company's consolidated
balance sheet.





Note 2: 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 Company’s wastewater
treatment and clean energy technologies and to fund the Company’s
liabilities, which as of September 30, 2010 include approximately $1,711,000 of
payroll tax liabilities (see Note 10), $5,333,000 of convertible debt securities
in default and $2,962,000 of other accruals (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, which involves 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. In addition, the
Company's former independent registered public accounting firm included in its
audit report on the Company’s financial statements as of and for the year ended
December 31, 2009 an explanatory paragraph indicating its doubts about the
Company's ability to continue as a going concern. Management is considering
several alternatives for mitigating these conditions.


7


THERMOENERGY
CORPORATION


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


September
30, 2010





Management
has determined that obtaining substantial additional funding is essential to its
continued existence. The Company and an investor group entered into a Series B
Convertible Preferred Stock Financing (the “2009 Financing”) in September 2009
that, if fully funded, would result in cash proceeds to the Company of
$6,250,000. This Financing was amended in March 2010 in conjunction with a
Bridge Loan Agreement to accelerate the funding of the third and fourth tranches
of the 2009 Financing. The Bridge Loan Agreement was amended on June 30, 2010 to
provide an additional $2 million of funding to the Company (see Note 4). Through
September 30, 2010 the Company has received $3,050,000 from the first and second
tranches of the 2009 Financing and $4,625,000 in proceeds from the Bridge Loan
Agreement. In July 2010 the third tranche of the 2009 Financing was triggered
through the announcement of the Company’s contract with the New York City
Department of Environmental Protection (“NYCDEP”), as discussed below. As a
result, $1,900,000 of Bridge Notes and accrued interest was exchanged for shares
of Series B Convertible Preferred Stock.





On May
11, 2010 the Company signed a contract with the NYCDEP related to the Company’s
Ammonia Removal Process System at the 26th Ward
wastewater pollution control plant. Total proceeds resulting from the contract,
which became effective on June 23, 2010, are estimated to be $27.1 million.
Under the contract, the Company will provide engineering and design services for
the rehabilitation of the Cake Storage Building, process equipment and other
systems at the 26th Ward
wastewater pollution plant; supply and install the Company’s proprietary ARP
equipment and operate and maintain the system at the plant for twelve
months.





On August
9, 2010 the Company issued to certain other investors a total of 2,083,334
shares of the Company’s Series B Convertible Preferred Stock at a purchase price
of $2.40 per share and warrants to purchase up to 33,333,344 shares of the
Company’s Common Stock. The total proceeds to the Company, net of issuance
costs, was $4,625,000.





Management
continues to actively pursue commercial contracts to generate revenues 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, the Company entered into a Limited Liability Company Agreement with
Babcock Power Development, LLC, a subsidiary of Babcock Power, Inc., for the
purpose of developing and commercializing our Zero Emission Boiler System
(“ZEBS”) technology.





Note 3: Babcock-Thermo
Carbon Capture LLC





On
February 25, 2009, the Company’s subsidiary, ThermoEnergy Power Systems LLC
(“TEPS”), 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 the Company’s proprietary ZEBS technology.





TEPS 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), worldwide, fully paid up and royalty-free license
to TEPS’s intellectual property related to or necessary to develop and
commercialize the ZEBS technology (the “ZEBS 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 ZEBS technology: a
combustor subsystem, a steam generating heating surface subsystem, and a
condensing heat exchangers subsystem. (collectively, the “Subsystems”) BPD has
entered into a license agreement with the Joint Venture and TEPS pursuant to
which it has granted the Joint Venture an exclusive, irrevocable (except as
otherwise provided therein), worldwide, fully paid up and royalty-free license
to BPD’s know-how and other proprietary intellectual property related to or
necessary to develop the Subsystems.





The Joint
Venture is 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. The Company and Babcock Power, Inc. have entered
into separate agreements to indemnify the Joint Venture, its
members and their respective affiliates against damages and losses
resulting from fraud, gross negligence or intentional misconduct of the
respective subsidiary-members with respect to the Joint
Venture.


8


THERMOENERGY
CORPORATION


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


September
30, 2010





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.





Pursuant
to the LLC Agreement, TEPS and BPD each own 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 its initial capital contribution of $50,000 in the
third quarter of 2009, made an additional capital contribution of $50,000 in the
first quarter of 2010. The Company also paid $9,000 of expenses on behalf of the
Joint Venture in the third quarter of 2010. The Company accounts for the Joint
Venture using the equity method of accounting. Accordingly, the Company reduced
the value of its investment in the Joint Venture by $64,000 in the second
quarter of 2010 and by $3,000 in the third quarter of 2010 to account for its
share of the net loss in the Joint Venture. The value of the Company’s
investment in the Joint Venture is $42,000 as of September 30, 2010 and is
classified as Other Assets on the Company’s Consolidated Balance
Sheets.





Note 4: Short-term
borrowings





Short-term
borrowings consisted of the following at September 30, 2010 and December 31,
2009 (in thousands):





September 30,
                      
                      
                      December 31,2010
                      
                      
                      20093%
      Bridge Loan dated March 1, 2010, due February 28, 2011, net of discount of
      $1,243 at September 30, 2010
                      
                      $
                      1,499
                      
                      
                      $
                      —$
                      1,499
                      
                      
                      $
                      —





On March
10, 2010, the Company entered into a Bridge Loan Agreement, effective March 1,
2010, with six of its principal investors (“the Investors”) pursuant to which
the Investors agreed to make bridge loans to the Company of up to $2.7 million
in exchange for 3% Secured Convertible Promissory Notes (the “Bridge Notes”).
The Bridge Notes bear interest at the rate of 3% per year and are due and
payable on February 28, 2011. The entire unpaid principal amount, together with
all interest then accrued and unpaid under each Bridge Note, is convertible, at
the election of the holder, into shares of Common Stock at a conversion price of
$0.24 per share.





The
Bridge Notes contain other conventional provisions, including the acceleration
of repayment obligations upon the occurrence of certain specified Events of
Default. The Bridge Notes are secured by all of the Company’s assets except for
the shares of the Company’s subsidiary, CASTion Corporation (in which no
security interest has been granted).





On June
30, 2010, the parties amended the Bridge Loan Agreement pursuant to which
certain of the Company’s investors agreed to increase by $2 million the amount
of the bridge loans as provided under the Bridge Loan Agreement. The new loans
made under the amended Bridge Loan Agreement have been made on terms identical
to the original loans under the Bridge Loan Agreement. The Company has received
proceeds totaling $4,625,000 under the Bridge Loan Agreement through September
30, 2010.





The
Company calculated the difference between the effective conversion price of the
Bridge Note and the fair value of the Company’s common stock as of each date of
issuance, resulting in a total beneficial conversion feature of $3,054,000,
representing the intrinsic value of the conversion feature on the respective
issuance dates. The value of the beneficial conversion feature is recorded as a
discount on the Bridge Notes and is amortized to interest expense over the
stated term of the Bridge Notes.


9


THERMOENERGY
CORPORATION


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


September
30, 2010





Pursuant
to the terms of the 2009 Financing, as discussed in Note 2, the Third
Tranche of the 2009 Financing became effective on July 8, 2010. In the Third
Tranche, $1.9 million of bridge loans and accrued interest was
converted into 791,668 shares of Series B Convertible Preferred Stock and
the Company issued warrants to purchase 8.3 million shares of stock at
$0.24 per share. As part of this conversion, the Company recorded a loss on
extinguishment of debt attributable to the unamortized debt discount on the
converted bridge loans in the amount of $614,000 in the third quarter of
2010.





Note 5: Convertible debt in
default





Convertible
debt in default consisted of the following at September 30, 2010 and December
31, 2009 (in thousands):





September
      30,
                      
                      
                      December
      31,2010
                      
                      
                      200918%
      Convertible Promissory Notes dated July 2, 2007, due May 31, 2010, net of
      discount of $0 at September 30, 2010 and $104 at December 31,
      2009
                      
                      $
                      4,929
                      
                      
                      $
                      4,13318%
      Convertible Promissory Notes dated January 5, 2009, due May 31,
      2010
                      
                      
                      404
                      
                      
                      
                      —$
                      5,333
                      
                      
                      $
                      4,133





The
Company issued Convertible Promissory Notes (the “Convertible Notes”) in the
aggregate principal amount of $3,353,127 as part of the consideration for the
acquisition of CASTion in July 2007. The Company then issued additional
Convertible Promissory Notes in the aggregate principal amount of $351,614 as
part of the consideration for the acquisition of the minority shareholders’
interest in CASTion in January 2009. The outstanding principal and accrued
interest are convertible into shares of the Company’s Common Stock at a
conversion price of $0.50 per share at the holders’ discretion. The Convertible
Notes contain conventional weighted-average anti-dilution provisions for the
adjustment of the conversion price of the Notes in the event the Company issues
additional shares of Common Stock (or securities convertible into Common Stock)
at a price less than the then-effective exercise price or conversion price. The
Convertible Notes matured on May 31, 2010.





Interest
on the Convertible Notes is payable semi-annually, and the Company has the
option of deferring interest payments and rolling the deferred amount into the
principal amount of the Notes. Deferred accrued interest amounts added to the
principal balances of the Convertible Notes totaled $1,576,000 at September 30,
2010 and $884,000 at December 31, 2009.





The
Convertible Notes are in default as disclosed in the table above, as the Company
has not repaid amounts due to the Noteholders upon maturity, and the Company did
not make required prepayments as detailed in the Convertible Promissory Note
agreements. Because the Convertible Notes are in default, the Company accrues
interest at the default interest rate of 18%.





On
October 20, 2010, in conjunction with the settlement reached between former
minority shareholders of CASTion Corporation (“CASTion”) and former majority
shareholders of CASTion as discussed in Note 10, the Company entered into a
settlement agreement with the former minority shareholders pursuant to which the
former minority shareholders converted notes plus accrued interest totaling
$433,000 into 1,802,445 shares of the Company’s Common Stock at a price of $0.24
per share.





The
Company is presently in negotiations related to the Notes held by the former
majority shareholders of CASTion.




10


THERMOENERGY
CORPORATION


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


September
30, 2010





Note 6: Convertible
debt





Convertible
debt consisted of the following at September 30, 2010 and December 31, 2009 (in
thousands):





September 30,
                                2010
                              
                              
                              December 31,
                                20095%
      Convertible Promissory Note, dated March 21, 2007, due March 21, 2013,
      less discounts of $145 at September 30, 2010 and $180 at December 31,
      2009
                              
                              $
                              749
                              
                              
                              $
                              6715%
      Convertible Promissory Note dated March 7, 2008, due March 7, 2013, less
      discount of $384 at September 30, 2010 and $494 at December 31,
      2009
                              
                              
                              465
                              
                              
                              
                              31510%
      Convertible Promissory Notes dated January 5, 2009, due May 31,
      2010
                              
                              
                              —
                              
                              
                              
                              384$
                              1,214
                              
                              
                              $
                              1,370





On March
21, 2007 the Company issued to Mr. Martin A. Roenigk, a member of the Company’s
Board of Directors as of that date, a 5% Convertible Promissory Note due March
21, 2013 in the principal amount of $750,000. The principal amount and accrued
interest on the Note is convertible into shares of the Company’s Common Stock at
a conversion price of $0.50 per share at any time at the election of the holder.
Interest on the Note is payable semi-annually. The Company may, at its
discretion, defer any scheduled interest payment until the maturity date of the
Note upon payment of a $2,500 deferral fee. Deferred accrued interest amounts
added to the principal balances of the Note totaled $144,000 at September 30,
2010 and $101,000 at December 31, 2009.





On March
7, 2008, Mr. Roenigk exercised his option to make an additional $750,000
investment in the Company under the terms of a Securities Purchase Agreement
between the Company and Mr. Roenigk dated March 21, 2007. The Company issued to
Mr. Roenigk a 5% Convertible Promissory Note due March 7, 2013 in the principal
amount of $750,000. The principal amount and accrued interest on the Note is
convertible into shares of Common Stock at a conversion price of $0.50 per share
at any time at the election of the holder. Interest on the Note is payable
semi-annually. The Company may, at its discretion, defer any scheduled interest
payment until the maturity date of the Note upon payment of a $2,500 deferral
fee. Deferred accrued interest amounts added to the principal balances of the
Note totaled $99,000 at September 30, 2010 and $59,000 at December 31,
2009.





Note 7:
Equity





Pursuant
to the terms of the 2009 Financing, as discussed in Note 2 the Third
Tranche became effective on July 8, 2010. In the Third Tranche, bridge
loans and accrued interest totaling $1.9 million were converted into
791,668 shares of Series B Convertible Preferred Stock and the
Company issued warrants to purchase 8.3 million shares of stock at $0.24
per share.





The
Company estimated the fair value of the warrants issued using a Black-Scholes
option pricing model and allocated all of the proceeds received to the warrants
on a relative fair value basis. Because the Series B Convertible Preferred Stock
is convertible at any time at the investor’s option, the total discount of $1.9
million is considered a “deemed dividend” to the investors of the Preferred
Stock as of the date of issuance and increases the net loss attributable to
common shareholders on the Company’s consolidated statement of
operations.





On August
9, 2010 the Company issued to certain investors a total of 2,083,334 shares of
the Company’s Series B Convertible Preferred Stock at a purchase price of $2.40
per share and warrants to purchase up to 33,333,344 shares of the Company’s
Common Stock. The total proceeds to the Company, net of issuance costs, was
$4,625,000. Each share of Series B Convertible Preferred Stock is convertible
into ten shares of the Company’s Common Stock at any time at the option of the
investor.


11


THERMOENERGY
CORPORATION


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


September
30, 2010





The
Warrants entitle the holders to purchase, at a price of $0.30 per share (subject
to adjustment for certain extraordinary corporate events as set forth in the
Warrant Agreements, the “Exercise Price”) that number of shares of the Company’s
Common Stock determined in each case by dividing (i) 200% of the aggregate cash
consideration paid by the holder for the shares of the Company’s Series B
Convertible Preferred Stock by (ii) the Exercise Price. The Warrants may be
exercised at any time on or before August 10, 2015, subject to the Company’s
right to accelerate the expiration date in the event the closing price for the
Company’s Common Stock exceeds 200% of the closing price on August 9, 2010 for a
period of 30 consecutive trading days. The Warrants contains other conventional
terms, including provisions for cashless exercise and 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.





The
Company estimated the fair value of the warrants issued using a Black-Scholes
option pricing model and allocated all of the proceeds received to the warrant
on a relative fair value basis. Because the Series B Convertible Preferred Stock
is convertible at any time at the investor’s option, the total discount of $5
million is considered a “deemed dividend” to the investors of the Preferred
Stock as of the date of issuance and increases the net loss attributable to
common shareholders on the Company’s consolidated statement of
operations.





As part
of the Securities Purchase Agreement, the Company agreed to prepare and file
with the Securities and Exchange Commission a registration statement to register
the shares of its Common Stock issuable upon conversion of the Preferred Shares
and exercise of the Warrants for resale by the investors. The registration
rights provisions of the Securities Purchase Agreement contain conventional
terms including indemnification and contribution undertakings.





At
September 30, 2010, approximately 208 million shares of the Company’s Common
Stock were reserved for future issuance under preferred stock agreements,
convertible debt and warrant agreements, stock option arrangements and other
commitments.





Stock
Options





During
2010, the Board of Directors awarded officers, employees, and various members of
the Board of Directors a total of 13,239,102 stock options under the Company’s
2008 Incentive Stock Plan. The options are exercisable at a range of $0.30 to
$0.34 per share for a ten year period. The exercise price was equal to or
greater than the market price on the respective grant dates during the
quarter.





The fair
value of options granted during 2010 and 2009 was estimated at the date of grant
using the Black-Scholes option pricing model with the following
assumptions:





2010
                      
                      
                      2009Risk-free
      interest rate
                      
                      2.6% - 3.8%
                      
                      
                      3.0% - 3.7%Expected
      option life (years)
                      
                      10.0
                      
                      
                      10.0Expected
      volatility
                      
                      80% - 97%
                      
                      
                      77%
      - 80%Expected
      dividend rate
                      
                      0%
                      
                      
                      0%





A summary
of the Company’s stock option activity and related information for the
nine-month periods ended September 30, 2010 and 2009 follows:


2010
                  
                  
                  2009Number of
                    Shares
                  
                  
                  Wtd. Avg.
                    Price per
                    Share
                  
                  
                  Number of
                    Shares
                  
                  
                  Wtd. Avg.
                    Price per
                    ShareOutstanding,
      beginning of year
                  
                  
                  11,203,800
                  
                  
                  $
                  1.18
                  
                  
                  
                  8,213,800
                  
                  
                  $
                  1.23Granted
                  
                  
                  13,239,102
                  
                  
                  $
                  0.30
                  
                  
                  
                  1,070,000
                  
                  
                  $
                  1.48Canceled
      and expired
                  
                  
                  (2,791,250
                  )
                  
                  $
                  1.67
                  
                  
                  
                  (700,000
                  )
                  
                  $
                  0.85Outstanding,
      end of period
                  
                  
                  21,651,652
                  
                  
                  $
                  0.58
                  
                  
                  
                  8,583,800
                  
                  
                  $
                  1.29Exercisable,
      end of period
                  
                  
                  7,217,479
                  
                  
                  $
                  1.13
                  
                  
                  
                  8,583,800
                  
                  
                  $
                  1.29


The
weighted average fair value of options granted was approximately $0.23 per share
and $0.30 per share for the nine-month periods ended September 30, 2010 and
2009, respectively. The weighted average fair value of options vested was
approximately $325,000 and $326,000 for the nine-month periods ended September
30, 2010 and 2009, respectively.


12


THERMOENERGY
CORPORATION


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


September
30, 2010





Exercise
prices for options outstanding as of September 30, 2010 ranged from $0.30 to
$1.75. The weighted average remaining contractual life of those options was
approximately 8.2 years at September 30, 2010. The weighted average remaining
contractual life of options vested and exercisable was approximately 6.0 years
at September 30, 2010.





As of
September 30, 2010, there was approximately $2.1 million of total unrecognized
compensation cost related to non-vested share-based compensation arrangements
granted under the Company’s stock option plan. That cost is expected to be
recognized over a weighted-average period of 1.4 years. The Company recognizes
stock-based compensation on the straight-line method.





Warrants





At
September 30, 2010, there were outstanding warrants for the purchase of
88,853,054 shares of the Company’s Common Stock at prices ranging from $0.24 per
share to $1.82 per share (weighted average exercise price was $0.41 per share).
The expiration date of these warrants are as follows:


Year
                  
                  Number of
                    Warrants2010
                  
                  
                  1,000,0002011
                  
                  
                  800,0002012
                  
                  
                  13,833,3332013
                  
                  
                  8,479,8842014
                  
                  
                  19,715,389After
      2014
                  
                  
                  45,024,44888,853,054





Note 8: Fair Value
Measurements





The
carrying amount of cash, accounts receivable, other current assets, accounts
payable, short-term notes payable and other current liabilities in the
consolidated financial statements approximate their fair value because of the
short-term nature of the instruments. The carrying amount of the Company’s
convertible debt in default and long-term convertible debt was $6,547,000 and
$5,503,000 at September 30, 2010 and December 31, 2009, respectively, and
approximates the respective fair value of these instruments. The derivative
liability for certain of the Company’s warrants are recorded at fair
value.





The
Company's assets and liabilities are measured using inputs from the three levels
of a fair value hierarchy, as follows:


Level
      1:
            Quoted
      prices in active markets for identical assets or
    liabilities.


Level
      2:
            Inputs
      other than Level 1 that are observable, either directly or indirectly,
      such as quoted prices for similar assets or liabilities; quoted prices in
      markets that are not active; or other inputs that are observable or can be
      corroborated by observable market data for substantially the full term of
      the assets or liabilities.


Level
      3:
            Unobservable
      inputs that are supported by little or no market activity and that are
      significant to the fair value of the assets or
  liabilities.





Liabilities
measured at fair value on a recurring basis as of September 30, 2010 are as
follows: (in thousands)





Fair Value Measurements at Reporting Date UsingQuoted Prices
                                in Active
                                Markets for
                                Identical Assets
                                (Level 1)
                              
                              
                              Significant
                                Other
                                Observable
                                Inputs
                                (Level 2)
                              
                              
                              Significant
                                Unobservable
                                Inputs
                                (Level 3)LiabilitiesDerivative
      liability
                              
                              $
                              -
                              
                              
                              $
                              -
                              
                              
                              $
                              2,880




13


THERMOENERGY
CORPORATION


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


September
30, 2010





The
following table sets forth a reconciliation of changes in the fair value of the
derivative liability classified as Level 3 (in thousands):


Long-Term Derivative
                              LiabilityBalance
      at December 31, 2009
                            
                            $
                            2,559Change
      in fair value
                            
                            
                            321Balance
      at September 30, 2010
                            
                            $
                            2,880





Note 9:
Segments





Operating
segments are identified as components of an enterprise about which separate
discrete financial information is available to the chief operating decision
maker, or decision-making group, in assessing performance and allocating
resources. The Company markets and develops advanced municipal and industrial
wastewater treatment and carbon reducing clean energy technologies. The Company
currently generates almost all of its revenues from the sale and application of
its water treatment technologies. Revenues from its clean energy technologies
have been limited to grants received from governmental and other agencies for
continued development. In 2009, the Company established Babcock-Thermo Carbon
Capture, LLC, a joint venture with Babcock Power Development, LLC, for the
purpose of developing and commercializing the Company’s clean energy technology.
As revenues and costs related to the Company’s clean energy technologies are
immaterial to the entire Company taken as a whole, the financial information
presented in these financial statements relates to the Company’s water treatment
technologies.





The
Company’s operations are currently conducted solely in the United States. The
Company will continue to evaluate how its business is managed and, as necessary,
adjust the segment reporting accordingly.





Note 10: Commitments and
contingencies





The
Company’s other accruals total $2,962,000 and $3,053,000 at September 30, 2010
and December 31, 2009, respectively, and consist of the following: (in
thousands)





September 30,
                          2010
                        
                        December 31,
                          2009Estimated
      penalties and interest – payroll tax liabilities
                        
                        $
                        2,332
                        
                        $
                        2,351Other,
      including unasserted claims
                        
                        
                        630
                        
                        
                        702$
                        2,962
                        
                        $
                        3,053





As of
September 30, 2010 the Company has accruals of $1,711,000 for payroll taxes and
$2,351,000 of estimated interest and penalties related to the non-payment of
payroll taxes from 2005 through the third quarter of 2009. The Company is
negotiating with the applicable state and federal taxing authorities to schedule
payment of these outstanding taxes. 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 former 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
respective tax authorities, the Securities and Exchange Commission or other
parties or the effect the actions may have on the Company’s results of
operations, financial condition or cash flows.




At
September 30, 2010, the Company had cash in financial institutions that exceeded
the amount insured by the Federal Deposit Insurance Corporation.





On April
21, 2010, Alexander G. Fassbender, the Company’s former Executive Vice President
and Chief Technology Officer, filed a Complaint in the Fairfax County, Virginia
Circuit Court alleging that his employment had been terminated in breach of his
employment agreement and claiming damages in the aggregate amount of
approximately $1 million, including unpaid salary, reimbursement of expenses,
and other payments under his employment agreement. The litigation is currently
in the discovery phase, and we are currently unable to estimate any loss or
range of loss. The Company is vigorously defending this
litigation.


14


THERMOENERGY
CORPORATION


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


September
30, 2010





In April
2010, a group representing former minority shareholders of CASTion Corporation
(“CASTion”) (“the Plaintiffs”) filed a Complaint in the Suffolk County,
Massachusetts Superior Court against CASTion’s former majority shareholders (the
“Defendants”) alleging claims arising out of the Defendants’ sale to the Company
of their shares of capital stock and other securities of CASTion. The Defendants
threatened to file a third party complaint against the Company (and others)
alleging, among other things, that the Company breached an obligation to the
Defendants in not extending to the Plaintiffs an offer to purchase the CASTion
securities held by them in a timely manner. On October 20, 2010 the Company, the
Plaintiffs and the Defendants entered into a settlement agreement resolving all
matters related to the Complaint.





Note 11: Subsequent
Event





On
October 20, 2010, in conjunction with the settlement reached between former
minority shareholders of CASTion Corporation (“CASTion”) and former majority
shareholders of CASTion as discussed in Note 10, the former minority
shareholders converted convertible notes plus accrued interest totaling
$433,000 into 1,802,445 shares of the Company’s Common Stock at a price of $0.24
per share.


15


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





We are a
clean technologies company engaged in the worldwide development of advanced
municipal and industrial wastewater treatment systems and carbon reducing clean
energy technologies (the “Technologies”).





We
develop and manufacture innovative wastewater treatment and recovery systems for
industrial and municipal clients. Our process systems not only meet local, state
and federal environmental regulations, but typically provide a rapid rate of
return on investment by recovering and reusing expensive feedstocks, reducing
contaminated wastewater discharge and recovering and reusing wastewater used in
process operations. Our patented Ammonia Recovery Process (“ARP”) is an
environmentally effective, low-cost method of treating wastewater discharge
streams containing nitrogen in the form of ammonia. It has been identified as a
key technological and competitive advantage in the industrial and municipal
wastewater treatment markets. Our patented and proprietary platform technology
is combined with off-the-shelf technologies to provide systems that are
inexpensive, easy to operate and reliable. Our wastewater treatment systems have
applications in aerospace, food and beverage processing, metal finishing, pulp
& paper, petrochemical, refining, microchip and circuit board manufacturing,
heavy manufacturing and municipal wastewater.





We are
also the majority owner of a patented clean energy technology known as the Zero
Emissions Boiler System (“ZEBS”), formerly known as ThermoEnergy Integrated
Power System (“TIPS”), which converts fossil fuels (including coal, oil and
natural gas) and biomass into electricity without producing air emissions, and
at the same time removes and captures carbon dioxide in liquid form for
sequestration or beneficial reuse. Through our majority-owned subsidiary,
ThermoEnergy Power Systems, LLC, we entered into a joint venture with Babcock
Power, Inc. called Babcock-Thermo Carbon Capture, LLC ("BTCC") to obtain the
resources necessary to facilitate the development and commercialization of this
technology. In conjunction with our joint venture partner, Babcock Power, Inc.,
we have changed the name of our carbon reducing energy technology from TIPS to
ZEBS. As our joint venture continues to develop this technology for
commercialization, we believe that the name change better reflects the broad
application of this radical new technology to build new or retrofit old fossil
fuel power plants globally with no emissions while capturing carbon dioxide as a
liquid for ready sequestration far more economically than any other competing
technology.





We
currently generate revenues from the sale and development of wastewater
treatment systems. We enter into contracts with our customers to provide a
wastewater treatment solution that meets the customer’s present and future
needs. Our revenues are tied to the size and scale of the wastewater treatment
system required by the customer, as well as the progress made on each customer
contract. From time to time, we receive funding from federal grants to continue
the development of ZEBS; however, there can be no assurance that such grants
will be available to us in the future.





There are
many federal, state and local statutes and regulations enacted to protect and
restore water and air quality. Federal legislation directed at improving water
quality include programs established under the Clean Water Act of 1977, as
amended, the Coastal Zone Management Act of 1972, as amended, the 1990 and 1996
Farm Bills, the Ocean Dumping Ban Act, and the Clean Water and Watershed
Restoration Initiative. The regulations established under these plans and others
are intended to improve existing water quality programs. In order to comply with
these regulations, municipal and industrial wastewater treatment facilities are
seeking more cost-effective methods of wastewater treatment. We believe that the
legislative environment will create additional opportunities to market our
Technologies.





We own or
license all of the technologies that we use in our business.





Results
of Operations





Comparison
of Quarters Ended September 30, 2010 and 2009





Contract
and grant revenues totaled $641,000 for the quarter ended September 30, 2010
compared to revenues of $970,000 for the quarter ended September 30, 2009. We
started engineering and design work on our contract with the New York City
Department of Environmental Protection (“NYCDEP”) in the third quarter of 2010;
revenues in the third quarter of 2010 are largely from this work. Revenues in
the third quarter of 2009 were primarily from production work on two large
industrial contracts. As a result of this more profitable activity, cost of
revenues decreased by $466,000 or 43% in the third quarter ended September 30,
2010 compared to the third quarter of 2009.


16


General
and administrative expenses decreased by $656,000 or 42% in the quarter ended
September 30, 2010 compared to 2009 due to reduced use of legal and other
professional services in 2010. Engineering and R&D expenses decreased by
$145,000 or 65% in the quarter ended September 30, 2010 compared to 2009, mainly
due to reduced headcount and application of engineering resources for the NYCDEP
contract in 2010. Sales and marketing expenses increased by $162,000 or 149% in
the quarter ended September 30, 2010 compared to 2009 due to increased pre-sales
activity and efforts made to increase our sales infrastructure. Non-cash stock
option expense totaled $559,000 in the third quarter of 2010 compared to $30,000
in the third quarter of 2009, an increase of $529,000. Non-cash stock option
expense in the third quarter of 2010 relates to the issuance of stock options to
our new Chief Executive Officer, Chief Financial Officer and certain key
employees in 2010. Warrant expense for the quarter ended September 30, 2009 is
the result of issuing warrants in conjunction with the issuance of convertible
notes in the third quarter of 2009, which resulted in the recording of an
expense of $727,000. We did not have any warrant activity for the quarter ended
September 30, 2010.





In the
third quarter of 2010, certain investors exchanged 3% Bridge Notes for Series B
Convertible Preferred Stock as part of the third tranche of our Series B
Convertible Preferred Stock financing (the “2009 Financing”). This resulted in a
loss on extinguishment of debt of $614,000 in the third quarter of 2010. In the
third quarter of 2009, as part of the first tranche of the 2009 Financing, we
modified the terms on $3.4 million of Convertible Notes with certain investors.
This resulted in a loss on extinguishment of debt of $1,208,000 in the third
quarter of 2009. Changes in the fair value of our derivative liability resulted
in the recognition of derivative income of $2,635,000 in the quarter ended
September 30, 2010. The income primarily relates to the decrease in our stock
price at September 30, 2010 compared to June 30, 2010. We did not recognize any
such income in the third quarter of 2009. Interest expense increased by $499,000
in the third quarter of 2010 compared to 2009, mainly due to amortization of
discounts on our Bridge Notes in 2010, partially offset by lower overall debt
levels resulting from the conversion of debt into Series B Convertible Preferred
Stock in the fourth quarter of 2009 and third quarter of 2010.





Comparison
of Nine-month Periods Ended September 30, 2010 and 2009





Contract
and grant revenues totaled $2,054,000 for the nine-month period ended September
30, 2010 compared to revenues of $2,608,000 for the nine-month period ended
September 30, 2009. In 2009, we were in the middle stages of production on two
large industrial contracts which comprised most of our revenues in 2009. One of
these contracts was substantially completed in the first quarter of 2010 while
the other was substantially completed in the second quarter of 2010. We started
engineering and design work on our contract with NYCDEP in the third quarter of
2010. As a result of this activity, cost of contract revenues for the nine-month
period ended September 30, 2010 decreased by $1,014,000 or 35% compared to the
nine-month period ended September 30, 2009.





General
and administrative expenses decreased by $1,183,000 or 32% in the nine-month
period ended September 30, 2010 compared to 2009 due to reduced use of legal and
other professional services in 2010. Engineering and R&D expenses decreased
by $275,000 or 40% in the nine-month period ended September 30, 2010 compared to
2009, mainly due to reduced headcount, application of engineering resources to
the NYCDEP contract and efforts diverted toward sales activity in 2010. Sales
and marketing expenses increased by $456,000 or 129% in the nine-month period
ended September 30, 2010 compared to 2009 due to increased sales activity and
efforts made to increase our pipeline. Non-cash stock option expense totaled
$1,562,000 in the nine-month period ended September 30, 2010 compared to
$211,000 in 2009, an increase of $1,351,000. Non-cash stock option expense in
2010 relates primarily to the issuance of stock options to our new Chief
Executive Officer, Chief Financial Officer and certain key employees in the
first quarter of 2010. Warrant expense for the nine months ended September 30,
2009 is the result of modifying certain warrants held by an investor in the
first quarter of 2009 and the issuance of warrants in conjunction with the
issuance of convertible notes in the third quarter of 2009, which resulted in
the recording of an expense of $1,757,000. We did not have any charges related
to warrant activity for the nine-month period ended September 30,
2010.





Changes
in the fair value of our derivative liabilities resulted in the recognition of a
non-cash derivative loss of $321,000 in the nine-month period ended September
30, 2010. We did not recognize any such expense in 2009.





Liquidity
and Capital Resources





Cash used
in operations amounted to $4.4 million and $3.1 million for the nine-month
periods ended September 30, 2010 and 2009, respectively. The increase in cash
used in operations is primarily due to deferring payments on operating
expenses from 2009 into 2010. This increased our liabilities in 2009 as we
sought additional funding from our investors. Cash used by investing activities
included an investment in our joint venture with Babcock Power and purchases of
property and equipment primarily related to new product investments during
2010.


17


At
September 30, 2010, we do not have sufficient working capital to satisfy our
anticipated operating expenses for the next 12 months. As of September 30, 2010,
we have a cash balance of approximately $5.7 million and current liabilities of
approximately $14.5 million, which consisted primarily of accounts payable of
$626,000, short-term borrowings of $2.7 million (exclusive of discounts of $1.2
million), convertible debt in default of $5.3 million, other accruals of
$3.0 million and unpaid payroll taxes of $1.7 million. We are presently in
negotiations with our creditors to extend, settle or convert certain of our
obligations to equity.





We have
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. We have funded our operations primarily from
the sale of convertible debt, bridge loans, preferred stock and restricted
stock, generally from stockholders and other related parties who are
sophisticated investors in clean technology. Although we will require
substantial additional funding to continue existing operations, we are
optimistic in our ability to obtain capital and debt financing given our recent
technological advantages in the markets in which we compete.





In
September 2009, we and an investor group engaged in a Series B Convertible
Preferred Stock Financing (the “2009 Financing”) that, if fully funded, will
result in cash proceeds of $6.25 million in four tranches. We effected the first
and second tranches of the 2009 Financing in the second half of
2009.





On March
10, 2010, we entered into a Bridge Loan Agreement, effective March 1, 2010, with
six investors who are parties to the 2009 Financing pursuant to which the
investors agreed to make bridge loans to us up to $2.7 million. We issued 3%
Secured Convertible Promissory Notes in the principal amount of each investor’s
funding commitment (the “Bridge Notes”). The Bridge Notes bear interest at the
rate of 3% per annum and are due and payable on February 28, 2011. The entire
unpaid principal amount, together with all interest then accrued and unpaid
under each Bridge Note, is convertible, at the election of the holder thereof,
into shares of Common Stock at a conversion price of $0.24 per share. We amended
the Bridge Loan Agreement in June 2010 to increase the amount of bridge loans by
$2 million. The new loans made under the amended Bridge Loan Agreement have been
made on terms identical to the original loans under the Bridge Loan Agreement.
We have received $4,625,000 in proceeds under the Bridge Loan
Agreement.





The
Bridge Loan Agreement amends the 2009 Financing such that the investors shall
surrender the Bridge Notes as payment for the Third Tranche Closing and/or the
Fourth Tranche Closing upon the occurrence of certain events. The Agreement also
makes further amendments to the Series B Convertible Preferred Stock Financing
to provide for additional warrant coverage based on the amounts advanced and
makes changes to funding commitments among the various investors. The Bridge
Notes are secured by a lien on all of our assets except for the shares of our
subsidiary, CASTion Corporation (in which no security interest has been
granted).





On June
24, 2010 we received from the NYCDEP an Order to Commence under the Contract
between us and the NYCDEP dated May 11, 2010 related to our Ammonia Removal
Process System at the 26th Ward
wastewater pollution control plant. Total billings under this contract are
estimated to be $27.1 million. Under the Contract, we have been engaged by the
NYCDEP to provide engineering and design services for the rehabilitation of the
Cake Storage Building, process equipment and other systems at the 26th Ward
wastewater pollution plant; supply and install our proprietary ARP equipment and
operate and maintain the system at the plant for twelve months. We have started
engineering and design work relative to this Contract in the third quarter of
2010.





Per the
terms of the 2009 Financing, the Third Tranche became effective five business
days after the filing of our Current Report on Form 8-K announcing the
commencement of the Contract. The Current Report on Form 8-K was filed on June
30, 2010, and the Third Tranche of the 2009 Financing became effective in July
8, 2010. We converted $1.9 million from the Bridge Loan and accrued interest
into shares of Series B Convertible Preferred Stock and issued warrants to
purchase 8.3 million shares of stock at $0.24 per share.





Through
September 30, 2010 we have received proceeds totaling $7.7 million from the 2009
Financing and the Bridge Loan Agreement, as amended. Of this amount, we received
$3.0 million in 2009 and $4.7 million in 2010.





On August
9, 2010 we issued to certain investors a total of 2,083,334 shares of our Series
B Convertible Preferred Stock at a purchase price of $2.40 per share and
warrants to purchase up to 33,333,344 shares of our Common Stock. The total
proceeds to us was $5 million before expenses. Each share of Series B
Convertible Preferred Stock is convertible into ten shares of our Common Stock
at any time at the option of the investor. The Warrants entitle the holders to
purchase shares of our Common Stock at a price of $0.30 per share (subject to
adjustment for certain extraordinary corporate events as set forth in the
Warrant Agreements). The Warrants may be exercised at any time on or before
August 10, 2015, subject to certain acceleration rights, and contain other
conventional terms, including provisions for cashless exercise and 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. As part of the Securities Purchase
Agreement, we agreed to prepare and file with the Securities and Exchange
Commission a registration statement to register the shares of our Common Stock
issuable upon conversion of the Preferred Shares and exercise of the Warrants
for resale by the investors. The registration rights provisions of the
Securities Purchase Agreement contain conventional terms including
indemnification and contribution undertakings.


18


On
October 20, 2010, in conjunction with the settlement reached between former
minority shareholders of CASTion Corporation (“CASTion”) and former majority
shareholders of CASTion, the former minority shareholders converted the
balance of convertible notes held by them, plus accrued interest, into
shares of our Common Stock at a price of $0.24 per share. As a result, notes and
interest totaling $433,000 were converted into 1,802,445 shares of our
Common Stock.





As of
September 30, 2010 we have accruals of $1,711,000 for payroll taxes and
$2,351,000 of estimated interest and penalties related to the non-payment of
payroll taxes from 2005 through the third quarter of 2009. We are negotiating
with the applicable state and federal taxing authorities to schedule payment of
these outstanding taxes. We may become subject to tax liens if we cannot
satisfactorily settle the outstanding payroll tax liabilities. Furthermore, due
to the actions of the former CFO, we may also face criminal and/or civil action
with respect to the impact of the payroll tax matters. We cannot predict what,
if any, actions may be taken by the respective tax authorities, the Securities
and Exchange Commission or other parties or the effect the actions may have on
our results of operations, financial condition or cash flows.





Due to of
our financial condition, there can be no assurance that we will be able to
obtain the funding necessary to continue its operations and development
activities in the future.





ITEM
3. Quantitative and Qualitative Disclosures About Market Risk





Not
applicable.





ITEM
4. Controls and Procedures.





The
Company, under the direction of its Chief Executive Officer and Chief Financial
Officer, has 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
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 as of the end of the period
covered by this report. Based on this 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 ineffective as of September 30, 2010.





Beginning
in the first quarter of 2010, the Company has contracted with finance personnel
with sufficient expertise and knowledge of accounting and financial reporting.
This has resulted in improvements in the preparation of timely and accurate
financial statements and disclosures as detailed in the Company’s Annual Report
on Form 10-K/A for the year ended December 31, 2009 and Quarterly Reports on
Form 10-Q for the quarters ended March 31, 2010 and June 30, 2010. Beginning in
the third quarter of 2010, the Company has developed and implemented processes
and procedures related to the proper accounting for its projects and related
contract administration. There have been no other changes in the Company’s
internal control over financial reporting that occurred during the quarter ended
September 30, 2010 that have materially affected, or are reasonably likely to
materially affect, the Company’s internal control over financial
reporting.





The
processes and procedures put in place to remediate previously disclosed material
weaknesses in our internal control over contract administration and accounting
procedures have not been implemented to a degree that management could, in its
judgment, declare that such processes and procedures are effective as of
September 30, 2010.


19


PART
II — OTHER INFORMATION





ITEM
1. Legal Proceedings





On April
21, 2010, Alexander G. Fassbender, the Company’s former Executive Vice President
and Chief Technology Officer, filed a Complaint in the Fairfax County, Virginia
Circuit Court alleging that his employment had been terminated in breach of his
employment agreement and claiming damages in the aggregate amount of
approximately $1 million, including unpaid salary, reimbursement of expenses,
and other payments under his employment agreement. The litigation is currently
in the discovery phase. The Company is vigorously defending this
litigation.





In April
2010, a group representing former minority shareholders of CASTion Corporation
(“CASTion”) (“the Plaintiffs”) filed a Complaint in the Suffolk County,
Massachusetts Superior Court against CASTion’s former majority shareholders (the
“Defendants”) alleging claims arising out of the Defendants’ sale to the Company
of their shares of capital stock and other securities of CASTion. The Defendants
threatened to file a third party complaint against the Company (and others)
alleging, among other things, that the Company breached an obligation to the
Defendants in not extending to the Plaintiffs an offer to purchase the CASTion
securities held by them in a timely manner. On October 20, 2010 the Company, the
Plaintiffs and the Defendants entered into a settlement agreement resolving all
matters related to the Complaint.





ITEM
1A. Risk Factors





Not
applicable.





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





None.





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 a majority interest in CASTion. The Company then issued
additional Convertible Promissory Notes in the aggregate principal amount of
$351,614 as part of the consideration for the acquisition of certain minority
shareholders’ interest in CASTion in January 2009. The balance of these Notes is
in default and is shown in current liabilities as of September 30, 2010, as the
Company did not make required prepayments as detailed in the Convertible
Promissory Notes and the Company has not repaid amounts due to the Noteholders
upon maturity of the Notes on May 31, 2010. Because the Notes are in default,
the Company accrues interest at the default interest rate of 18%.





On
October 20, 2010, in conjunction with the settlement reached between former
minority shareholders of CASTion Corporation (“CASTion”) and former majority
shareholders of CASTion as discussed in Item 1, above, the former minority
shareholders converted convertible notes plus accrued interest totaling
$433,000 into shares 1,802,445  of our Common Stock at a price of
$0.24 per share.




The
Company is presently in negotiations related to the Notes held by the former
majority shareholders of CASTion.





ITEM
4. Other Information





None.


20


ITEM
5. Exhibits





The
following exhibits are filed as part of this report:





Exhibit No.
                
                Description of Exhibit3(i)
                
                Certificate
      of Incorporation of ThermoEnergy Corporation, as amended through August 4,
      2010 - Incorporated by reference to Exhibit 3(i) to Current Report on Form
      8-K filed August 9, 201010.1
                
                Securities
      Purchase Agreement dated as of August 9, 2010 by and among Security Equity
      Fund, Mid Cap Value Fund; SBL Fund, Series V (Mid Cap Value); Security
      Equity Fund, Mid Cap Value Institutional Fund; SBL Fund, Series Q (Small
      Cap Value); and Security Equity Fund, Small Cap Value Fund and
      ThermoEnergy Corporation - Incorporated by reference to Exhibit 10.1 to
      Current Report on Form 8-K filed August 9, 201031.1
                
                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


21


SIGNATURE





Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.





Date:
      November 15, 2010
                THERMOENERGY CORPORATION/s/
      Cary G. BullockCary G. Bullock, President andChief
      Executive Officer




Date:
      November 15, 2010
                  /s/
      Teodor Klowan, Jr.Teodor
      Klowan, Jr. CPA, ExecutiveVice
      President and Chief FinancialOfficer
  22