UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
DC 20549





FORM
10-Q





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





For
the quarterly period ended June 30, 2010





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





For
the transition period
from          to





Commission
File Number 33-46104-FW





THERMOENERGY
CORPORATION


(Exact
Name of Registrant as Specified in Its Charter)





Delaware
            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)





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





Indicate
by check mark whether the registrant: (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (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 August 12, 2010 - 53,679,473
shares





THERMOENERGY
CORPORATION





INDEX





Page
                  No.Part
      I.
                Financial
      InformationITEM
      1.
                Financial
      Statements
                
                3Consolidated
      Balance Sheets as of June 30, 2010 (Unaudited) and December 31,
      2009
                
                3Consolidated
      Statements of Operations for the three and six months ended June 30, 2010
      and 2009 (Unaudited)
                
                4Consolidated
      Statements of Cash Flows for the six months ended June 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
                
                15ITEM
      3.
                Quantitative
      and Qualitative Disclosures About Market Risk
                
                18ITEM
      4.
                Controls
      and Procedures
                
                18Part
      II.
                Other
      InformationITEM
      1.
                Legal
      Proceedings
                
                19ITEM
      1A.
                Risk
      Factors
                
                19ITEM
      2.
                Unregistered
      Sales of Equity Securities and Use of Proceeds
                
                19ITEM
      3.
                Defaults
      Upon Senior Securities
                
                19ITEM
      4.
                Other
      Information
                
                19ITEM
      5.
                Exhibits
                
                19Signature
                
                
                
                21


2


PART
I – FINANCIAL INFORMATION





ITEM
1.  Financial Statements





THERMOENERGY
CORPORATION


CONSOLIDATED
BALANCE SHEETS


(in
thousands, except share and par value amounts)





June 30,
                          2010
                        
                        
                        December 31,
                          2009(unaudited)ASSETSCurrent
      Assets:Cash
                        
                        $
                        1,782
                        
                        
                        $
                        1,109Accounts
      receivable, net
                        
                        
                        1,027
                        
                        
                        
                        7Inventories,
      net
                        
                        
                        62
                        
                        
                        
                        74Other
      current assets
                        
                        
                        273
                        
                        
                        
                        205Total
      Current Assets
                        
                        
                        3,144
                        
                        
                        
                        1,395Property
      and equipment, net
                        
                        
                        267
                        
                        
                        
                        241Other
      assets
                        
                        
                        60
                        
                        
                        
                        74Total
      Assets
                        
                        $
                        3,471
                        
                        
                        $
                        1,710LIABILITIES
      AND STOCKHOLDERS' EQUITY (DEFICIT)Current
      Liabilities:Accounts
      payable
                        
                        $
                        968
                        
                        
                        $
                        812Short-term
      borrowings
                        
                        
                        1,882
                        
                        
                        
                        —Convertible
      debt in default, net
                        
                        
                        5,300
                        
                        
                        
                        4,133Contingent
      liability reserves
                        
                        
                        2,981
                        
                        
                        
                        3,053Deferred
      revenue
                        
                        
                        841
                        
                        
                        
                        398Other
      current liabilities
                        
                        
                        2,941
                        
                        
                        
                        3,627Total
      Current Liabilities
                        
                        
                        14,913
                        
                        
                        
                        12,023Long
      Term Liabilities:Deferred
      compensation retirement plan for officers, net of current
      portion
                        
                        
                        204
                        
                        
                        
                        229Derivative
      liability
                        
                        
                        5,515
                        
                        
                        
                        2,559Convertible
      debt, net
                        
                        
                        1,123
                        
                        
                        
                        1,370Total
      Long Term Liabilities
                        
                        
                        6,842
                        
                        
                        
                        4,158Total
      Liabilities
                        
                        
                        21,755
                        
                        
                        
                        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
      June 30, 2010 and December 31, 2009
                        
                        
                        2
                        
                        
                        
                        2Class
      B Convertible Preferred Stock, liquidation preference of $2.40 per share:
      designated: 4,371,287 shares; issued and outstanding: 3,037,954 shares at
      June 30, 2010 and December 31, 2009
                        
                        
                        30
                        
                        
                        
                        30Common
      Stock, $.001 par value: authorized - 300,000,000 shares; issued:
      53,763,270 shares at June 30, 2010 and December 31, 2009; outstanding:
      53,679,473 shares at June 30, 2010 and December 31, 2009
                        
                        
                        54
                        
                        
                        
                        54Additional
      paid-in capital
                        
                        
                        70,484
                        
                        
                        
                        66,711Treasury
      stock, at cost: 50,000 shares at June 30, 2010
                        
                        
                        (16
                        )
                        
                        
                        —Accumulated
      deficit
                        
                        
                        (88,838
                        )
                        
                        
                        (81,268
                        )Total
      Stockholders’ Equity (Deficit)
                        
                        
                        (18,284
                        )
                        
                        
                        (14,471
                        )TOTAL
      LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
                        
                        $
                        3,471
                        
                        
                        $
                        1,710





See notes
to consolidated financial statements.


3


THERMOENERGY
CORPORATION


CONSOLIDATED
STATEMENTS OF OPERATIONS


In
thousands, except share and per share amounts


(Unaudited)





Six Months Ended
                    June 30,
                  
                  Three Months Ended
                    June 30,2010
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Contract
      and grant revenue
                  
                  $
                  1,413
                  
                  
                  $
                  1,638
                  
                  
                  $
                  253
                  
                  
                  $
                  1,262Less:
      cost of contract and grant revenue
                  
                  
                  1,304
                  
                  
                  
                  1,852
                  
                  
                  
                  138
                  
                  
                  
                  1,372Gross
      profit (loss)
                  
                  
                  109
                  
                  
                  
                  (214
                  )
                  
                  
                  115
                  
                  
                  
                  (110
                  )Operating
      Expenses:General
      and administrative
                  
                  
                  1,615
                  
                  
                  
                  2,142
                  
                  
                  
                  842
                  
                  
                  
                  1,207Engineering
      and R&D
                  
                  
                  341
                  
                  
                  
                  472
                  
                  
                  
                  146
                  
                  
                  
                  185Sales
      and marketing
                  
                  
                  539
                  
                  
                  
                  245
                  
                  
                  
                  266
                  
                  
                  
                  160Stock
      option expense
                  
                  
                  1,003
                  
                  
                  
                  181
                  
                  
                  
                  591
                  
                  
                  
                  20Warrant
      expense
                  
                  
                  —
                  
                  
                  
                  1,030
                  
                  
                  
                  —
                  
                  
                  
                  —Total
      operating expenses
                  
                  
                  3,498
                  
                  
                  
                  4,070
                  
                  
                  
                  1,845
                  
                  
                  
                  1,572Loss
      from operations
                  
                  
                  (3,389
                  )
                  
                  
                  (4,284
                  )
                  
                  
                  (1,730
                  )
                  
                  
                  (1,682
                  )Other
      income (expense):Derivative
      loss
                  
                  
                  (2,956
                  )
                  
                  
                  —
                  
                  
                  
                  (3,071
                  )
                  
                  
                  —Interest
      expense
                  
                  
                  (1,161
                  )
                  
                  
                  (1,148
                  )
                  
                  
                  (717
                  )
                  
                  
                  (581
                  )Equity
      in net loss of joint venture
                  
                  
                  (64
                  )
                  
                  
                  —
                  
                  
                  
                  (64
                  )
                  
                  
                  —Net
      loss
                  
                  $
                  (7,570
                  )
                  
                  $
                  (5,432
                  )
                  
                  $
                  (5,582
                  )
                  
                  $
                  (2,263
                  )Loss
      per share, basic and diluted
                  
                  $
                  (0.14
                  )
                  
                  $
                  (0.10
                  )
                  
                  $
                  (0.10
                  )
                  
                  $
                  (0.04
                  )Shares
      used in computing loss per share, basic and diluted
                  
                  
                  53,679,473
                  
                  
                  
                  52,019,133
                  
                  
                  
                  53,679,473
                  
                  
                  
                  53,054,942





See notes
to consolidated financial statements.


4


THERMOENERGY
CORPORATION


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(in
thousands)





(Unaudited)
                    Six Months Ended
                    June 30,2010
                  
                  
                  2009Operating
      Activities:Net
      loss
                  
                  $
                  (7,570
                  )
                  
                  $
                  (5,432
                  )Adjustment
      to reconcile net loss to net cash used in operating
      activities:Stock
      option expense
                  
                  
                  1,003
                  
                  
                  
                  181Warrant
      expense
                  
                  
                  —
                  
                  
                  
                  1,030Warrants
      issued for services
                  
                  
                  —
                  
                  
                  
                  46Common
      stock issued for services
                  
                  
                  —
                  
                  
                  
                  188Equity
      in net loss of joint venture
                  
                  
                  64
                  
                  
                  
                  —Derivative
      loss
                  
                  
                  2,956
                  
                  
                  
                  —Depreciation
                  
                  
                  26
                  
                  
                  
                  34Provision
      for inventory reserves
                  
                  
                  9
                  
                  
                  
                  —Amortization
      of discount on convertible debt
                  
                  
                  626
                  
                  
                  
                  746Increase
      (decrease) in cash arising from changes in assets and
      liabilities:Accounts
      receivable
                  
                  
                  (1,020
                  )
                  
                  
                  88Inventories
                  
                  
                  3
                  
                  
                  
                  3Other
      current assets
                  
                  
                  (68
                  )
                  
                  
                  108Accounts
      payable
                  
                  
                  156
                  
                  
                  
                  228Deferred
      revenue
                  
                  
                  443
                  
                  
                  
                  388All
      other current liabilities
                  
                  
                  (52
                  )
                  
                  
                  866Deferred
      compensation retirement plan
                  
                  
                  (25
                  )
                  
                  
                  (7
                  )Net
      cash used in operating activities
                  
                  
                  (3,449
                  )
                  
                  
                  (1,533
                  )Investing
      Activities:Investment
      in joint venture
                  
                  
                  (50
                  )
                  
                  
                  —Purchase
      of property and equipment
                  
                  
                  (52
                  )
                  
                  
                  —Net
      cash used in investing activities
                  
                  
                  (102
                  )
                  
                  
                  —Financing
      Activities:Proceeds
      from short-term borrowings
                  
                  
                  4,224
                  
                  
                  
                  —Proceeds
      from issuance of Common Stock and warrants
                  
                  
                  —
                  
                  
                  
                  500Proceeds
      from convertible promissory notes
                  
                  
                  —
                  
                  
                  
                  958Net
      cash provided by financing activities
                  
                  
                  4,224
                  
                  
                  
                  1,458Net
      change in cash
                  
                  
                  673
                  
                  
                  
                  (75
                  )Cash,
      beginning of period
                  
                  
                  1,109
                  
                  
                  
                  115Cash,
      end of period
                  
                  $
                  1,782
                  
                  
                  $
                  40Supplemental
      schedule of non-cash financing activities:Capitalization
      of paid-in-kind interest
                  
                  $
                  720
                  
                  
                  $
                  204





See notes
to consolidated financial statements.


5


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 accounting principles generally accepted in the United States of
America for interim financial information and with the instructions to Form 10-Q
and Article 8-03 of Regulation S-X. (“GAAP”)  Accordingly, they do not
include all of the information and notes required by GAAP for complete financial
statements.  In the opinion of management, all adjustments (consisting
of normal recurring accruals) considered necessary for a fair presentation have
been included.  Operating results for the three and six-month periods
ended June 30, 2010 are not necessarily indicative of the results that may be
expected for the year ending December 31, 2010.





Net loss
per common share is computed by dividing the net loss for the period by the
weighted average number of shares outstanding during the
period.  Stock options, warrants, and the dilutive effect of the
Company’s convertible debt, short-term notes payable, 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 but does not include all of the information and
footnotes required by GAAP for complete financial statements.





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





Revenue
earned from grants are based on allowable costs and labor.  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 income and
recognized in the period in which revisions are determined.





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 June 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.





Inventory





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





We
evaluate our inventory for excess 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 June 30, 2010 and December 31, 2009, respectively.


6


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 contingent
liability reserves 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 contingent
liabilities may be materially different from previous estimates and could
require adjustments to the estimated reserves 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 .  This  requires
that the cost of all share-based payments to employees, including grants of
employee stock options, be 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 initially 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 (the “Technologies”) and to fund the
Company’s liabilities, which included approximately $1,988,000 of payroll tax
liabilities (see Note 10), $5,300,000 of convertible debt securities in default
and $2,981,000 of contingent liability reserves (see Note 10).  In
addition, the Company may be subject to tax liens if it cannot satisfactorily
settle the outstanding payroll tax liabilities and may also face criminal and/or
civil action with respect to the impact of the payroll tax matters (see Note
10).  The financial statements have been prepared assuming the Company
will continue as a going concern, realizing assets and liquidating liabilities
in the ordinary course of business, and do not reflect any adjustments that
might result from the outcome of the aforementioned uncertainties. In addition,
the Company's former independent registered public accounting firm included in
its report 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.





Management
has determined that obtaining substantial additional funding is essential to its
continued existence.  Management is actively engaged in negotiations
with a group of investors that have provided funding to the Company in the
past.  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 the
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)  As of June 30, 2010 the Company has received $3,050,000 from the
first and second tranches of the 2009 Financing and $4,225,000 in proceeds from
the Bridge Loan Agreement.


7


On May
11, 2010 the Company signed a contract with the New York City Department of
Environmental Protection (“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.





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 practice 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 practice 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 and its
members (other than our respective subsidiary-members) and their respective
affiliates against damages and losses resulting from fraud, gross negligence or
intentional misconduct of our respective subsidiary-members with respect to the
Joint Venture.





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





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 and made an additional
capital contribution of $50,000 in the first 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 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 $36,000 as of June 30, 2010 and is classified as Other
Assets on the Company’s Consolidated Balance Sheets.


8


Note
4:  Short-term borrowings





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





2010
                                          
                                          
                                          2009Bridge
      Loan dated March 1, 2010, 3%, due February 28, 2011, net of discount of
      $2,343 at June 30, 2010
                                          
                                          $
                                          1,882
                                          
                                          
                                          $
                                          —$
                                          1,882
                                          
                                          
                                          $
                                          —





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 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 Loan Agreement amends the Series B Convertible Preferred Stock Financing
Agreement entered in September 2009 such that the Investors shall surrender the
Bridge Notes as payment for the Third Tranche Closing and/or the Fourth Tranche
Closing upon the execution of certain events as detailed in said
agreement.  The Bridge Loan 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 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 Company 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 received $4,225,000 in proceeds under the
Bridge Loan Agreement as of June 30, 2010 and an additional $400,000 on July 2,
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 $2,770,000, 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.





As
discussed in Note 2, 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.  Per the terms of the 2009
Financing, the Third Tranche becomes effective five business days after the
filing of the Company’s 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 on July 8,
2010.  The Company converted $1.9 million from the Bridge Loan
Agreement 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.


9


Note
5:  Convertible debt in default





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





2010
                      
                      
                      2009Convertible
      Promissory Notes dated July 2, 2007, 18%, due May 31, 2010, net of
      discount of $0 at June 30, 2010 and $104 at December 31,
    2009
                      
                      $
                      4,854
                      
                      
                      $
                      4,133Convertible
      Promissory Notes dated January 5, 2009, 18%, due May 31,
    2010
                      
                      
                      446
                      
                      
                      
                      —$
                      5,300
                      
                      
                      $
                      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 $1,595,000 at
June 30, 2010 and $884,000 at December 31, 2009.





The
Convertible Notes are in default as of June 30, 2010 and December 31, 2009, 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%.  The Company is presently in negotiations with these Noteholders
to extend the maturity dates of these Convertible Notes, convert these
Convertible Notes into equity or enter a settlement agreement with the
Noteholders.





Note
6:  Convertible debt





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





June 30,
                          2010
                        
                        
                        December 31,
                          2009Convertible
      Promissory Note, 5% dated March 21, 2007, due March 21, 2013, less
      discounts of $157 at June 30, 2010 and $180 at December 31,
      2009
                        
                        $
                        715
                        
                        
                        $
                        671Convertible
      Promissory Note dated March 7, 2008, 5%, due March 7, 2013, less discount
      of $421 at June 30, 2010 and $494 at December 31, 2009
                        
                        
                        408
                        
                        
                        
                        315Convertible
      Promissory Notes dated January 5, 2009, 10%, due May 31,
    2010
                        
                        
                        —
                        
                        
                        
                        384$
                        1,123
                        
                        
                        $
                        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.  The Company added $21,000 of accrued interest to
the principal balance of the Note as of June 30, 2010.





On March
7, 2008, Mr. Roenigk exercised his option to make an additional $750,000
investment in the Company under the terms of the 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.  The
Company added $20,000 of accrued interest to the principal balance of the Note
as of June 30, 2010.


10


Note
7:  Equity





At June
30, 2010, approximately 132 million shares of the Company’s Common Stock were
reserved for future issuance under convertible debt and warrant agreements,
stock option arrangements and other commitments.





Stock
Options





During
the first quarter of 2010, the Board of Directors awarded officers, employees,
and various members of the Board of Directors a total of 13,039,102 stock
options in conjunction with the Company’s 2008 Incentive Stock
Plan.  The options are exercisable at $0.30 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 Company
did not issue any stock options in the second quarter of 2010.





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





2010
                      
                      
                      2009Risk-free
      interest rate
                      
                      3.6%
      - 3.8%
                      
                      
                      3.0%
      - 3.5%Expected
      option life (years)
                      
                      10.0
                      
                      
                      10.0Expected
      volatility
                      
                      80%
                      
                      
                      77%Expected
      dividend rate
                      
                      0%
                      
                      
                      0%





A summary
of the Company’s stock option activity and related information for the six-month
periods ended June 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
                                          
                                          
                                          13,039,102
                                          
                                          
                                          $
                                          0.30
                                          
                                          
                                          
                                          1,070,000
                                          
                                          
                                          $
                                          1.48Canceled
      and expired
                                          
                                          
                                          (1,627,500
                                          )
                                          
                                          $
                                          1.99
                                          
                                          
                                          
                                          (100,000
                                          )
                                          
                                          $
                                          0.54Outstanding,
      end of period
                                          
                                          
                                          22,615,402
                                          
                                          
                                          $
                                          0.61
                                          
                                          
                                          
                                          9,183,800
                                          
                                          
                                          $
                                          1.27Exercisable,
      end of period
                                          
                                          
                                          7,176,925
                                          
                                          
                                          $
                                          1.28
                                          
                                          
                                          
                                          9,183,800
                                          
                                          
                                          $
                                          1.27





The
weighted average fair value of options granted were approximately $0.23 per
share and $0.33 per share for the six-month periods ended June 30, 2010 and
2009, respectively.  The weighted average fair value of options vested
was approximately $64,000 and $340,000 for the six-month periods ended June 30,
2010 and 2009, respectively.





Exercise
prices for options outstanding as of June 30, 2010 ranged from $0.30 to
$1.75.  The weighted average remaining contractual life of those
options was approximately 8.0 years at June 30, 2010.  The weighted
average remaining contractual life of options vested and exercisable was
approximately 7.6 years at June 30, 2010.





As of
June 30, 2010, there was $2,593,000 of total unrecognized compensation cost
related to non-vested share-based compensation arrangements granted under the
Company’s stock option plans.  That cost is expected to be recognized
over a weighted-average period of 1.7 years.  The Company recognizes
stock-based compensation on the straight-line method.


11


Warrants





At June
30, 2010, there were outstanding warrants for the purchase of 47,219,710 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 $0.54 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
                            
                            
                            3,391,10447,219,710





Note 8:  Fair
Value Measurements





The
carrying amount of cash, accounts receivable, inventories, other current assets,
accounts payable, short-term notes payable and other current liabilities in the
consolidated financial statements approximate 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
$6,423,000 and $5,503,000 at June 30, 2010 and December 31, 2009, respectively,
and approximates the respective fair value of these
instruments.   The Company’s warrant liabilities are recorded at
fair value.





The
Company's assets and  liabilities are measured using inputs from the
three levels of 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
  liabilities.





Liabilities
measured at fair value on a recurring basis as of June 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
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    5,515





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





Long-Term Derivative
                        LiabilityBalance
      at December 31, 2009
                      
                      $
                      2,559Change
      in fair value
                      
                      
                      2,956Balance
      at June 30, 2010
                      
                      $
                      5,515





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 is immaterial to the entire Company taken as a whole, the
financial information presented in these financial statements represents all the
material financial information related to the Company’s water treatment
technologies.


12


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 contingent liability reserves total $2,981,000 and $3,053,000 at June
30, 2010 and December 31, 2009, respectively, and consist of the following: (in
thousands)





June 30,
                                    2010
                                  
                                  
                                  December 31,
                                    2009Estimated
      penalties and interest – payroll tax liabilities
                                  
                                  $
                                  2,351
                                  
                                  
                                  $
                                  2,351Other,
      including unasserted claims
                                  
                                  
                                  630
                                  
                                  
                                  
                                  702$
                                  2,981
                                  
                                  
                                  $
                                  3,053





The
Company has accrued $2,941,000 in other current liabilities, which includes
$1,988,000 for unpaid payroll taxes as of June 30, 2010 in addition to the
contingency accrual for estimated penalties and interest, as detailed
above.  Management has filed the payroll tax returns and is working
with the various federal and state taxing authorities to present an offer in
compromise for settlement of the payroll tax liabilities.  The Company
has made payments to the various taxing authorities totaling $635,000 in the
first two quarters of 2010.  The Company cannot predict the outcome of
the offer in compromise proceedings. The remaining liability is for various
other operating accruals.





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 Company’s 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 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 June
30, 2010, the Company had cash in financial institutions that exceeded the limit
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.  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 have 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.  The Defendants are seeking contribution from the Company in
the amount of any damages that may be assessed against the Defendants on the
Plaintiffs’ claims, as well as indemnification for legal fees and other
damages.  The Company, the Plaintiffs and the Defendants have engaged
in mediation and are seeking a settlement agreement in return for dismissing all
claims.  No settlement has been finalized at this
time.


13


Note
11:  Subsequent Event





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 amount paid to the Company was $5
million.  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.





The
Warrants entitle the holders to purchase, at a purchase price of $0.30 per share
(subject to adjustment for certain extraordinary corporate events as set forth
in the Warrants, 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.


14


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.





We
develop and manufacture innovative wastewater treatment and recovery systems to
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.  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, through our
majority-owned subsidiary, ThermoEnergy Power Systems, LLC, 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.





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
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 Quarter Ended June 30, 2010 and 2009





Contract
and grant revenues totaled $253,000 for the quarter ended June 30, 2010 as
compared to revenues of $1,262,000 for the quarter ended June 30,
2009.  In 2009, we were in the early stages of production on two large
contracts. 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. Because we completed production on these two projects, cost of
revenues for the quarter ended June 30, 2010 decreased by $1,234,000 or 90%
compared to the quarter ended June 30, 2009.  In June 2010, we entered
into a $27,100,000 contract with the City of New York to deploy a
state-of-the-art ammonia recovery system at the City's 26th Ward Wastewater
Treatment Plant on Jamaica Bay. Work on the project began in the quarter. We
expect this project to have a significant effect on our revenue and cost of
revenue in the future.


15


General
and administrative expenses decreased by $365,000 or 30% in the quarter ended
June 30, 2010 compared to 2009 due to reduced use of legal and other
professional services in 2010.  Engineering and R&D expenses
decreased by $39,000 or 21% in the quarter ended June 30, 2010 compared to 2009,
mainly due to reduced headcount in 2010.  Sales and marketing expenses
increased by $106,000 or 66% in the quarter ended June 30, 2010 compared to 2009
due to increased pre-sales activity and efforts made to increase our
sales.  Non-cash stock option expense totaled $591,000 in the second
quarter of 2010 compared to $20,000 in the second quarter of 2009, an increase
of $571,000.  Non-cash stock option expense in the second quarter of
2010 relates 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.





Changes
in the fair value of our derivative liabilities resulted in the recognition of
derivative loss of $3,071,000 in the quarter ended June 30, 2010.  The
charge primarily relates to the increase in our stock price at June 30, 2010
compared to March 31, 2010 and increasing the expected volatility rate
assumption used as of June 30, 2010.  We did not recognize any such
expense in the second quarter of 2009.  Interest expense increased by
$136,000 in the second quarter of 2010 compared to 2009, mainly due to
amortization of discounts on our Bridge Notes in 2010, offset by lower overall
debt levels resulting from the conversion of debt into Series B Convertible
Preferred Stock in the fourth quarter of 2009, all of which were non-cash in
nature.





Comparison
of Six-Month Period Ended June 30, 2010 and 2009





Contract
and grant revenues totaled $1,413,000 for the six-month period ended June 30,
2010 compared to revenues of $1,638,000 for the six-month period ended June 30,
2009.  In 2009, we were in the early stages of production on two large
contracts. 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. Because we completed production for our two largest wastewater
projects early in the second quarter of 2010, cost of contract revenues for the
six-month period ended June 30, 2010 decreased by $548,000 or 30% compared to
the six-month period ended June 30, 2009.





General
and administrative expenses decreased by $527,000 or 25% in the six-month period
ended June 30, 2010 compared to 2009 due to reduced use of legal and other
professional services in 2010.  Engineering and R&D expenses
decreased by $131,000 or 28% in the six-month period ended June 30, 2010
compared to 2009, mainly due to reduced headcount and efforts in 2010 diverted
toward sales activity.  Sales and marketing expenses increased by
$294,000 or 120% in the six-month period ended June 30, 2010 compared to 2009
due to increased sales activity and efforts made to increase our
pipeline.  Non-cash stock option expense totaled $1,003,000 in the
six-month period ended June 30, 2010 compared to $181,000 in the second quarter
of 2009, an increase of $822,000.  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.  We modified warrants held by the Quercus Trust
in the first quarter of 2009, which resulted in the recording of an expense of
$1,030,000.  We did not have any warrant activity for the six-month
period ended June 30, 2010.





Changes
in the fair value of our derivative liabilities resulted in the recognition of
derivative loss of $2,956,000 in the six-month period ended June 30,
2010.  The charge primarily relates to the increase in our stock price
at June 30, 2010 compared to December 31, 2009 and increasing the expected
volatility rate assumption used as of June 30, 2010.  We did not
recognize any such expense in 2009.





Liquidity
and Capital Resources





Cash used
in operations amounted to $3,449,000 and $1,533,000 for the six-month periods
ended June 30, 2010 and 2009, respectively.  The increase in cash used
from operations is primarily due to deferring payments on operating expenses in
2009, which 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 of $50,000 and purchases of
property and equipment of $52,000 during 2010.





At June
30, 2010, we did not have sufficient working capital to satisfy our anticipated
operating expenses for the next 12 months. As of June 30, 2010, we had a cash
balance of approximately $1.8 million and current liabilities of approximately
$14.9 million, which consisted primarily of accounts payable of $968,000,
short-term borrowings of $4.2 million (exclusive of discounts of $2.3 million),
convertible debt in default of $5.3 million, contingent liability reserves of
$3.0 million and unpaid payroll taxes of $1.9 million.  We are
presently in negotiations with our creditors to extend, settle or convert our
obligations to equity.


16


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.  As of June
30, 2010 we have received $3.05 million from the first and second tranches of
the 2009 Financing.





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.





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).





As
further discussed below, on June 24, 2010 we received from the New York City
Department of Environmental Protection (“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.  Per the terms of the 2009
Financing, the Third Tranche becomes 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.





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
expect to commence work relative to this Contract in the third quarter of
2010.





On June
30, 2010, we amended the Bridge Loan Agreement pursuant to which our investors
agreed to increase by $2 million the amount of the bridge loans to us 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.  We received
$4,225,000 in proceeds under the Bridge Loan Agreement as of June 30, 2010, and
we received an additional $400,000 on July 2, 2010.





As more
fully discussed in Note 10 of Notes to Consolidated Financial Statements, as of
June 30, 2010 we have accruals of $1,988,000 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 the Company’s results of
operations, financial condition or cash flows.





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 amount paid to us was $5 million.  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.


17


The
Warrants entitle the holders to purchase, at a purchase price of $0.30 per share
(subject to adjustment for certain extraordinary corporate events as set forth
in the Warrants, the “Exercise Price”) that number of shares of our Common Stock
determined in each case by dividing (i) 200% of the aggregate cash consideration
paid by the holder for the shares of our 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 our right to accelerate the expiration
date in the event the closing price for our 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.





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 June 30, 2010, due to the existence of
previously disclosed material weaknesses in our internal control over financial
reporting primarily related to deficient contract administration and accounting
procedures, that we have yet to fully remediate.





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.  There have been no other changes in the Company’s internal
control over financial reporting that occurred during the quarter ended June 30,
2010 that have materially affected, or are reasonably likely to materially
affect, the Company’s internal control over financial
reporting.


18


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 have 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.  The Defendants are seeking contribution from the Company in
the amount of any damages that may be assessed against the Defendants on the
Plaintiffs’ claims, as well as indemnification for legal fees and other
damages.  The Company, the Plaintiffs and the Defendants have engaged
in mediation and are seeking a settlement agreement in return for dismissing all
claims.  No settlement has been finalized at this time.





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 June 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%.  The Company is presently in negotiations with the holders of
these Notes.





ITEM
4.  Other Information





None.





ITEM
5.  Exhibits





The
following exhibits are filed as part of this report:





ExhibitNo.
                
                Description of Exhibit10.1
                
                Contract
      No. PO-98B (Registration No. CTC 826 20101417884) between The City of New
      York Department of Environmental Protection and ThermoEnergy Corporation —
      Incorporated by reference to Exhibit 10.1 to Current Report on Form 8-K
      filed June 30, 2010


19





10.2
              
              Amendment
      No. 1 to Bridge Loan Agreement dated as of March 1, 2010 by and among The
      Quercus Trust, Robert S. Trump, Focus Fund, L.P., Empire Capital Partners,
      LP, Empire Capital Partners, Ltd, and Empire Capital Partners Enhanced
      Master Fund Ltd (collectively, the “Investors”) and ThermoEnergy
      Corporation—
      Incorporated by reference to Exhibit 10.1 to Current Report on Form 8-K
      filed July 2, 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


20





SIGNATURE





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





Date:
      August 16, 2010
                THERMOENERGY
      CORPORATION/s/ Cary G. BullockCary
      G. Bullock, President andChief
      Executive Officer


21